Inflation Expectations and the Economic Agenda
"The key is to wait. Sometimes the hardest thing to do is to do nothing." - David Tepper Inflation gets sparked by underlying economic forces, sometimes systemic and sometimes temporary in nature. One such force was the Covid shock, which led to a massive decrease in aggregate supply as well as demand. With rates at 1.50-1.75% before the economic halt, the Fed opened its toolbox and responded with massive stimulus across the board. "What's the Fed doing in response to the Covid-19 crisis? What more could it do?" - Brooking, March 30, 2021 "What the wise man does in the beginning, the fool does in the end." - Warren Buffett Rattled by the unprecedented response to a single event, markets hit peak pessimism right after options expiration in March of 2020. The human psyche was geared for stocks near zero and distressed bonds that would never see a bid again. Risk assets were ripe for a bottom. Since then, the Fed has adopted average inflation targeting of 2% and has maintained accommodative policy. With the November meeting upon us, the FOMC is largely expected to announce tapering and end treasury & MBS purchases by the middle of next year. Time and again, though, Jay Powell has stressed the distinction between tapering and hiking rates; if anything, the committee is open to varying the pace of tapering. Despite the Fed's clear language on rate hikes, inflation is now rivaling employment in terms of mentions. This week, Paul Tudor Jones and David Einhorn voiced their opinion on the dangers of inflation and the Fed's role: "As inflation has refused to resolve itself quickly and on its own, Fed Chair Powell revised his description to “frustrating.” But why should he feel frustrated? It’s not like he has done his best to fight inflation without success; he hasn’t lifted a finger to fight inflation. Instead, he has maintained a policy designed to create inflation." - Greenlight Capital "Paul Tudor Jones: Inflation is the number one issue facing investors" - CNBC So, what are the Fed's expectations for the economic landscape and what are markets pricing in? Keep in mind: Markets don't trade in absolute terms, they react relative to expectations! Zero Coupon Inflation SWAPS
20yr (purple line), 10yr (white line), 5yr (blue line), 2yr (orange line)
Alongside the steep rise in inflation expectations on the short end, 10 and 20 year SWAPS have remained above the Fed's 2% target.
Implied Policy Rate
Markets are surely ahead of the Fed's schedule on rate hikes and high CPI prints will not change the trajectory of expectations. It is not crazy to think that there's no good policy response to high inflation at this point and unless the central bank has to use drastic measures, it won't.
As supply shortages are expected to get resolved over time, will a prolonged economic recovery produce even stickier inflation? Will resolutions on the supply-side set-off pent-up demand? To what degree are markets willing to tolerate inflation>economic growth?
Median Consumer Price Index
PCE and PCEPI
"The personal consumption expenditure price index (PCEPI) is one measure of U.S. inflation, tracking the change in prices of goods and services purchased by consumers throughout the economy. Of all the measures of consumer price inflation, the PCEPI includes the broadest set of goods and services." - Federal Reserve Bank of San Francisco
G10 Inflation, Rates, and Money Supply
Reasons for sticky inflation:
Shelter is continuing to accelerate as the CPI's rent component is lagging massive increases in housing prices
Rents in urban areas have started to pick up
Higher energy prices and a lack of CAPEX from energy companies in the west; Transformation to renewables
Supply chain shortages have led to empty shelves
Labor shortages leading to higher wages -- exacerbated by a declining labor participation rate and a change in mindset from Millennials and GenZ
Household wealth might get unleashed in the face of rising inflation expectations
Reasons against inflation:
Deflationary forces from technology
Supply chain bottlenecks will be resolved and ports will start accepting containers again (Tweet from Ryan Peterson, Flexport CEO)
Rolling lockdowns across APAC come to an end
There are many more arguments on both sides of the coin and we encourage you to check out some of our prior writings on the energy markets as well as housing.
This Week's Economic Agenda:
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Is China Set For Accelerating Economic Growth?
China has been the world's growth driver for more than a decade and commodities across the board are impacted by the country's policies. After a period of crackdowns against the nation's tech giants, real estate developers, as well as tutoring services, is investor sentiment set to swing back in a more positive direction?
"China Hints Its Crackdowns on Tech Giants is Coming to an End" - Yahoo Finance
China was the first country to be hit and also come out of the pandemic, leading to a slower economy in the recent past.
If slow growth has not puzzled commodity prices, what will a more friendly economic landscape in China mean going forward?
As China gears up for the Beijing Winter Olympics in 2022 and urbanization continues, are we set for a wave of fiscal spending?