The Federal Reserve remains in a precarious bind on inflation, investors and analysts say.
U.S. inflation is showing signs of moderating, but not by enough to decisively settle the debate on whether the recent pace of price rises is transitory or not.
The July consumer price index report, which showed the headline annual rate remaining at a 20-year high of 5.4%, leaves the Federal Reserve in a still-precarious bind. Should future inflation readings surprise to the upside or stay elevated in coming months and into 2022, the risk is that consumer expectations for higher prices will become more deeply embedded and harder to reverse, investors and analysts say.
And for now, the central bank is not in a position to do much about that risk other than talk about it, given its two best options for taking action aren’t in the cards for a while. For now, the Fed is focused on whether, when, and by how much to pare back on its $120 billion in monthly bond purchases first. So it could easily take at least a year before the central bank delivers its first interest rate increase — which typically takes another six to nine months to impact the economy. Meanwhile, policy makers’ other option besides a rate hike — shrinking the Fed’s $8.2 trillion balance sheet — isn’t currently on the radar.
“One of our greatest concerns is for a stagflation-like environment, in which there’s weakening growth and higher-than-average inflation that the Fed can’t do much about,” said Alan McKnight, chief investment officer of Birmingham-based Regions Bank, which oversees more than $47 billion in assets. “It’s a non-base-case scenario, but that’s the risk out there.”
In a phone interview, McKnight said his baseline forecast calls for the CPI’s headline annual rate to diminish to around 4% this year, accompanied by 6.1% real GDP growth — both of which should slip to 2.8% and 5.3%, respectively, in 2022. In anticipation of the risks to that outlook, he says his firm has already lowered its allocations to large-cap U.S. stocks, while cutting its fixed-income holdings “across the board” because “it’s difficult to see a scenario where U.S. bonds do well” in an environment of higher inflation that leads to rising market-based rates.
Following Wednesday’s release of the CPI print, longer-term Treasury yields such as the 10-year
extended gains, leaving them near the highest levels in almost a month. They still remain below where they were for much of this year, however — which some see as a sign of an impending economic slowdown and/or the bond market’s continued confidence in the Fed’s ability to control inflation. Meanwhile, breakeven rates reflecting where traders see inflation heading five to 10 years out have moderated since May.
With each passing month, though, “there’s been a little bit more evidence that some components of inflation are poised to keep increasing and the risk factors have grown,” said Greg McBride, chief financial analyst for Bankrate.com, an online provider of rates information. “The reality of it is that it’s going to be early 2022 before we know definitively whether price pressures are transitory. And at that point, the Fed is behind the curve.”
Complicating the Fed’s options on the inflation front is what’s likely to be a months-long tapering process, which a growing number of people inside and outside the central bank say should begin soon. Many regard tapering as the first step toward tightening financial conditions, though JPMorgan Chase & Co. strategists, Federated Hermes Inc. portfolio manager R.J. Gallo, and others throw cold water on the notion that reducing bond purchases alone will be enough to tighten as much as people think.
“Tapering is still expansionary, albeit at a lower rate,” said Fergus Hodgson, director at Econ Americas, an equity-research firm. For the Fed, “the risk is that you make permanent the inflation expectations and are playing with fire.”
At least one policy maker, James Bullard of the Federal Reserve Bank of St. Louis, is pushing for a faster tapering process than many expect — one that starts this fall and ends by March; he sees a risk that some of this year’s inflation surge lasts into 2022. Meanwhile, senior Fed official Richard Clarida has flagged early 2023 as a time when the central bank could possibly begin raising rates, as long as the economy makes enough progress before then.
At the moment, investors say, both the Fed and bond markets appear positioned for an optimal outcome — one in which the transition to less accommodation from the central bank occurs in a seamless fashion without jeopardizing economic growth, while inflation comes down, over the next 12-18 months.
“Stagflation is a scary word,” says Gene Goldman, the El Segundo, California-based chief investment officer and research director at Cetera Financial Group. He says he sees a risk of something more like a “stagflation-lite” — in which inflation doesn’t necessarily surge dramatically from here, but “the Fed is behind the 8-ball.”