By Philip Lawlor, head of Global Investment Research
Booming commodity prices and the surprisingly robust US CPI reading for April have cranked up market anxieties that the Federal Reserve might be forced to change guidance on QE tapering sooner rather than later. The inflation wild card is likely to keep markets volatile in the months ahead.
US inflation heats up
The quickening pace of the US reopening has already prompted a rash of upgrades to 2021 GDP forecasts, including those of the Fed (from 4.2% at year-end 2020 to 6.5% currently). While market-implied inflation expectations have risen globally, they are at decade highs for the US, as shown below. The year-on-year surge in April CPI (the strongest since 2008) and surging commodity prices have all added fuel to the inflation-fear fires.
What the Fed is watching
But the Fed is showing no signs of budging from its current stance. Officials have been adamant in their commitment to the new, more patient policy framework, which puts a keener focus on achieving employment goals than previous regimes. They also continue to expect reopening price pressures to level off as shipping and supply pathways clear and demand normalizes. The Fed’s preferred metric – core personal consumption expenditures (PCE) – is still below target and historically low, while the April figures for jobs and wage growth were also more muted than expected.
But financial markets continue to test the Fed’s dovish policy resolve. The US bond market has already undergone a jarring repricing of inflation risk this year, which catapulted the 10-year Treasury yield more than 80 basis points to a high of 1.73% in mid-March.
Futures markets foresee the Fed and Bank of England making their first rate hikes in mid-2022 ‒ well ahead of other central banks and their own official timelines ‒ and a steeper trajectory for US rates thereafter.
Will the Jackson Hole summit bring answers?
Base effects, pandemic-induced supply disruptions and a long history of false dawns are muddying the long-term inflation outlook. It may be months before a clear picture of the underlying inflation trend emerges. That said, however, the sequence and timing of Fed moves following the 2013 Taper Tantrum may offer some perspective.
The 2013 Taper Tantrum was triggered by the mere hint of an approaching Fed policy shift. The Fed did not begin winding down its asset purchases until late 2014, and the first rate hike was in December 2015. As shown below, long Treasury yields and inflation breakevens fell steadily over that 30-month period before climbing again with the official tightening regime.
Whether the leap in inflation proves temporary or longer lasting (i.e., hot enough to force a shift in Fed guidance) is likely to remain a heated debate for months to come, amplifying the focus on US jobs, wages and inflation releases. More clarity could come this August, when the world’s central bankers meet at their annual Jackson Hole symposium, an occasion that officials often use to make important pronouncements about policy and shifts in thinking.
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