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Rising Inflation May Be a Lesser Risk Than a Fed Mistake: Strategists

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What You Need to Know

  • Many strategists say inflation has already peaked or is about to, but price pressures will remain.
  • There are risks that prices stay above pre-pandemic levels.
  • TIPS have been the top performer among U.S. bond market categories year-to-date.

Despite the surge in U.S. inflation this year to a 31-year high, many Wall Street bond strategists and economists say inflation has likely already peaked or is on the verge of doing so. Still, they are watching closely for any missteps by the Federal Reserve, which could exacerbate inflation pressures.

“The inflation overshoot has been startling but so far is attributable to a surge in durable goods prices driven by surprisingly severe and persistent supply-demand imbalances,” wrote Goldman Sachs chief economist Jan Hatzius in his recent economic outlook. “We do expect persistent inflationary pressure from faster growth of wages and rents, but only enough to keep inflation moderately above 2%, in line with the Fed’s goal under its new framework.”

In the most recent government readings, consumer prices rose at an annualized rate of 6.2% in October (4.6% excluding food and energy) — the biggest jump since November 1990. Personal consumption expenditures (PCE), the Fed’s favorite price gauge, increased at a 4.4% annualized rate and 3.6% excluding food and energy.

The Fed has an inflation target of 2%, but under a new policy framework adopted in August 2020, it will tolerate inflation rising above that target for some time so that the rate averages 2% over time and the economy achieves “maximum employment.” The Fed defines maximum employment as the highest level of employment or the lowest level of unemployment that can be sustained while the inflation rate is stable.

Here’s what some leading economists and bond strategists are saying or writing about the outlook for inflation next year.

Chris Brown, co-portfolio manager for U.S. Total Return Bond Strategy, T. Rowe Price

“The Fed has a tough task in front of it — convincing markets that tapering is not tightening and that flexible average inflation targeting (FAIT) is alive — but it’s achievable,” Brown writes in the firm’s annual outlook report. “Inflation is the fulcrum.”

Tapering refers to the Fed’s reduction in asset prices, which is set to start in December and is expected to end around June 2022 assuming there are no major changes to the economy or economic outlook between now and then. Then Fed rate hikes are expected to follow in the second half of 2022 or early 2023. The CME FedWatch Tool is forecasting a roughly 70% chance of a Fed hike in June of either 25 or 50 basis points.

Brown expects price pressures will ease in 2022 from recent highs but not to levels that persisted pre-COVID pandemic. Before price pressures ease, however, inflation could head higher, according to Brown.

He’s more worried about the Fed hiking rates too soon than about the impact of rising inflation because a preemptive rate hike could “snuff out the recovery.” The Fed last raised rates in December 2018.

Jan Hatzius, chief economist, Goldman Sachs

“We do expect persistent inflationary pressure from faster growth of wages and rents but only enough to keep inflation moderately above 2%, in line with the Fed’s goal under its new framework.

“The current inflation surge will get worse this winter before it gets better, but as supply-constrained categories shift from a transitory inflationary boost to a transitory deflationary drag, we expect core PCE inflation to fall from 4.4% at end-2021 to 2.3% at end-2022.”

Hatzius expects two rate hikes by the Federal Reserve this year — in July and November —  followed by two hikes per year thereafter.

Kathy Jones, chief fixed income strategist, Schwab Center for Financial Research

“The Fed has emphasized its willingness to let inflation overshoot 2% for a period of time in order to allow more time for the unemployment rate to fall. Nonetheless, several Fed officials have indicated concerns about inflation recently. Even Fed Chair Jerome Powell indicated that inflation has lasted ‘longer than expected’ and that the Fed would favor raising rates if there are ‘serious risks of higher inflation expectations.’”

More on this topic

Jones is watching two indicators to monitor a potential Fed rate move: inflation expectations, as measured by the breakeven rate for TIPS, which is the difference between the yield of a TIPS and the yield of nominal Treasury of similar maturities, and the employment-to-population ratio, which measures the ratio of people employed compared to the working-age population of a region.

“Currently, inflation expectations have risen but mostly for shorter time horizons,” writes Jones.  “With short-term breakeven rates higher than long-term breakeven rates, the market is pricing in declining inflation rates over the long run compared to today’s elevated readings.”

Mark Hafele, chief investment officer, Global Wealth Management at UBS

“We expect currently elevated rates of inflation to subside over the course of 2022, as supply-demand mismatches resolve, energy prices stabilize, and labor market frictions ease.”

If, however, inflation proves to be “sticky,” staying higher for longer, then “a sustained rise in consumer prices could start to weigh on consumer demand” and the Fed, nevertheless, could hike rates “too soon, too quickly, or too far.”

Alternatively, a Fed failure to raise rates in the face of “transitory shocks,” would also be problematic, according to Hafele. It would “de-anchor consumer and business inflation expectations, leading to self-fulfilling inflation and requiring central banks to hike rates aggressively to regain credibility.”

In its best-case scenario, UBS expects year-over-year rates of inflation to fall from 6.5% at the end of 2021 to 1.8% by the end of 2022 and for 10-year yields to rise to 2% by the end of 2021, “reducing the pressure on consumers, interest rates, and corporations and supporting equities.”

UBS expects the Fed will raise rates for the first time in years in 2023.

John Lovito, co-chief investment officer — global fixed income, American Century Investments

Lovito says inflation problems in the U.S. go “beyond transitory” and are “cyclical and structural” because shelter costs and wages will continue to be elevated.

“The Fed will have to play catchup. It’s been doing a slow walk until now and will probably have to move a little faster than expected … maybe speed up tapering.”

Starting in December the Fed will reduce its asset purchases of $120 billion a month by $15 billion — cutting Treasury purchases by $10 billion and mortgage-backed securities purchases by $5 billion and ending the taper by mid-2022.

Lovito expects two Fed rate hikes in 2022 but three in 2023.

“The market has to come to grips with a different Fed monetary policy. We don’t know what that will look like and if the Fed will be able to control inflation as they have in the past … Buy TIPS.”

Treasury inflation-protected securities (TIPS) have been outperforming other categories of U.S. bonds, according to Morningstar.