"Rising up, back on the street..."
- Survivor, Eye of the Tiger
Over recent weeks, inflation has become the focal topic in financial markets. The trending topic of debate. However, set against the emergency policy settings of the global central banks – not to mention fiscal dominance within the pandemic recovery – the inferences drawn from inflation expectations (high or low) have, so far at least, not been what many commentators may have suggested.
Headline inflation in the US rose to 2.6% y/y in March, above what I suspect would ordinarily be the tolerance band for the ‘somewhat above 2%’ framework of the Fed’s new average inflation target (setting aside the ‘for some time’ caveat). Indeed, markets are expecting a significantly higher headline print in April – well above 3%. Furthermore with core PCE expected to rise to target over coming months and the growth rate expected to accelerate further from the 6.4% q/q annualised rate it achieved in Q1, what is holding back the Federal Open Market Committee (FOMC) from slowly reducing the level of monetary stimulus in the US economy?
The Fed rate meeting and press conference this week saw rates left unchanged and quantitative easing (QE) purchases maintained at USD 120B per month (Treasuries and MBS). However, the focus of markets was on the forward-looking narrative, any hint as to the timing of the start of normalisation: Are they ready to start ‘talking about talking about tapering’?
Going into the meeting, consensus expectations were for a more positive growth narrative. Specifically, the market was looking for an updated characterisation of growth in the opening statement and commentary on the prospects for inflation (‘firmer, but transitory’) and whether this impacts the recent forward guidance; and together, whether these factors have amounted to ‘substantial further progress’ towards the FOMC’s goals of price stability and (the newly asymmetric) full employment. In short, markets got exactly what they expected.
The Fed Chairman was clear that while inflation (at least on the headline measure) is above target (PCE to follow), that there are specific pandemic / reopening factors that mean the current inflation pressures are transitory – namely, that the base effects of commodity and other price inputs are distorted by the pandemic and notable supply shortages / bottlenecks, as demand rebounds are factors that will resolve themselves over time; in essence, the suggestion was that these factors will not be responsive to a tightening of monetary conditions, and thus the Fed will not attempt to fight them.
While ultimately, we would agree that the likely medium-term inflation impulse remains relatively muted, for the remainder of this year inflation is likely to feel very real, from many different parts of the US economy. As such, this debate, market pressure and the work of the Fed to maintain the credibility of its mandate, are far from over. Further, with the Fed’s own forecasts expecting core PCE inflation at target at the policy relevant forecast horizon, pressure for the Fed to signal a tapering of asset purchases (the most likely first stage of monetary normalisation) is unlikely to wane any time soon.
Indeed, the price action of US breakeven yields (a gauge of inflation expectations), suggests that the Fed’s ‘transitory’ narrative did little to calm inflation expectations – which are now at their highest since 2013.
Furthermore, it is perhaps interesting that while the ‘transitory inflation’ theme is broadly accepted (at least in the terms of an excessive overshoot in long term price pressures), many commentators seem very keen to extrapolate indefinitely near-term growth trajectories – for Europe in particular.
As we move towards the normalisation of growth in the global economy, it is important to bear in mind a few factors. Firstly, that while reopening growth trajectories may be steep, they will ultimately revert back to trend; and further, it is this trend growth that will ultimately determine the sustainability of debt dynamics and likely govern future capital flows. Secondly, that the absolute levels of rates matter.
Many commentators are keen to point out that at some point (Q3?) the eurozone will have a faster (transitory?) rate of growth than the US and therefore the EUR should outperform the USD (a view that was not reciprocated during periods – like the current period – when the opposite is true). It is possible that the equivalent absolute pace of growth over a transitory period may be higher, but we retain the view that the equilibrium growth rate of the US remains significantly higher (double, according to IMF estimates, post pandemic), than that of the eurozone.
Furthermore, if we are right in the view that the capital account is more important than the current account, then the absolute level of yields is another crucial factor. For a number of US assets, returns even on a currency hedged basis have become attractive to foreign capital.
Lastly, we return to the topic of the recovery itself. A recent report from the European Systemic Risk Board (ESRB), chaired by the European Central Bank (ECB) President, has stated that the eurozone is at risk of a ‘tsunami of bankruptcies’ as the recovery evolves, and the blanket fiscal support measures are eased. This is of course a risk for many countries, including the UK, and is exacerbated at the individual level by the expiry of furlough and self-employment fiscal support. Indeed, there is even a natural extrapolation at the country level. The ECB has provided significant support for peripheral spreads – actively targeting monetary transmission across the region and narrowing spreads to their tightest in many years despite the increasingly disparate credit dynamics.
Obviously, we are extremely encouraged by the progress of all nations in fighting the pandemic and excited at the prospect of a global recovery. However, we continue to see differentiation as a key metric (unlike the synchronous global recovery from the global financial crisis). Therefore, while many are focussed on the impending acceleration of non-US economies, looking for this to signify the start of a synchronous recovery, I for one am more inclined to see the recovery of non-US economies as the point of further acceleration of differentiation, as the US has a higher equilibrium or trend growth rate, will likely suffer fewer withdrawal symptoms from the expiry of stimulus, and had fewer pre-existing conditions going into the crisis.
The Fed Chairman was determined to emphasise that economic activity had not made ‘substantial further progress’ towards the Fed’s policy goals. In part, at least, the Fed is shielded by the distortions to the inflation dynamic in the recovery phase – the ‘transient’ base effects and supply bottlenecks that are generating above trend inflation pressures. At the same time, the Fed is clear in the desire not just to attain full employment, but to attain full employment for every subset of the labour force. In combination, the Fed is effectively foot to the floor with the handbrake on.
Progress towards the Fed’s goals may not yet be substantial, by the Fed’s as yet undefined criteria, but the wheels are starting to spin!
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