The US Federal Reserve finally acknowledged inflation is not a “transitory” problem and signalled a greater degree of concern; but investors seem to think that the Fed will blink when markets balk. With consumer inflation at multi-decade highs and COVID-19 risks still alive, what’s next for the monetary policy response—and market implications—as we move into 2022? Our Fixed Income CIO Sonal Desai shares her views.
The Federal Reserve (Fed) finally acknowledged that high inflation is not transitory—but markets believe its resolve to fight it is.
It was high time for the Fed to recognise we have an inflation problem on our hands. Already with the June release, when US Consumer Price Index (CPI) inflation rose above 5%, I had noted that significant price increases were not limited to a few outliers but had spread to several goods and services categories.
Since then, it’s become even clearer that inflation pressures are broad-based and not just due to base effects: core CPI reached 4.6% year-over-year (Y/Y) in October and has been at or above 4% for five consecutive months. Alternate measures of inflation like the San Francisco Fed’s Cyclical Core PCE and the New York Fed’s Underlying Inflation Gauge have also risen sharply. Headline inflation jumped to a 31-year high of 6.2% Y/Y.
Over a year ago, we at Franklin Templeton Fixed Income were already an outlier with our significantly above-consensus inflation call. Four months ago, I again flagged the risk that markets and policymakers might still be underestimating inflation, and I pointed to two factors: the likelihood that high inflation would show a significant degree of inertia, and the dichotomy between consumers and businesses, who expected inflation to persist, and most financial investors who appeared convinced it would not.
Inflation inertia is now baked in the cake. Suppose that the inflation reading for November drops back to 0.2% month-over-month (M/M)—the 2017-2019 average—and stays there. Y/Y inflation will still remain above 6% until next February, and average 5.5% in the 12-month period through May 2022. And that now seems like a best-case scenario, because M/M inflation has averaged 0.6% since the beginning of the year.
Suppose that M/M inflation remains at 0.6% for a while longer, let’s say another six months—remember, it’s already averaged 0.6% for the past 10 months. In that case, Y/Y inflation would rise above 7% in December, peak at close to 8% in February-March, and only drop below 5% a year from now. What’s more, inflation would average 5.4% over a full two years, 2021-2022.
The longer inflation stays in the 5%-6% range, the more it changes the behaviour and expectations of consumers and producers. The anecdotal evidence is piling up: companies are getting used to being charged higher input prices and to charging higher prices for their products—that’s a regime shift from the last many years. Workers are negotiating higher wages with labour demand still outstripping supply. By the middle of next year, these behaviour changes will have become even more ingrained.
Fed Chairman Jerome Powell has finally acknowledged it’s time to retire the “transitory” moniker. First in a recent speech and then testifying to Congress, he conceded that “transitory” can mean different things to different people. Indeed. Does it mean a few months? A few quarters? A few years? He said that for the Fed it means that “it will not lead to permanently or very persistently higher inflation”. Well, nothing in life is permanent, and “very persistent” is also rather ambiguous. Would one year of inflation above 5% qualify? Because that’s already looking like a best-case outcome, as I noted above.
In a recent seminar, Powell also admitted that the Fed’s “patient” approach might not be a perfect match for an environment of sustained supply bottlenecks and energy price increases, and for the first time he sounded more concerned about inflation than about unemployment. Markets took notice and got nervous, and the five-year breakeven rate rose well above 3%.