June 24, 2021- 2:51 p.m.
Investors are struggling to interpret the Federal Reserve’s signals of how hot it is to drive inflation ahead of launching a pandemic-era monetary stimulus.
Markets’ measures of US inflation expectations hit multi-year highs in mid-May, but fell after comments from some Fed speakers and minutes of the committee’s April meeting looked more alarming.
Some investors interpreted that policymakers have less tolerance for inflation overhang than previously estimated.
The fall in inflation expectations was intensified by the central bank’s policymaking meeting on June 15-16, when the Fed pushed forward its first two rate hikes in 2023. Since then, bets on inflation have turned back, possibly helped by Fed Chair Jerome Powell insisting on Tuesday that the bank would not raise rates beforehand because of “fear” of coming inflation.
The yearning shows that investors are struggling to understand the sometimes conflicting signals from Fed officials, who are facing their first inflation test under a new flexible average inflation framework adopted in 2020.
“There is a lot of uncertainty among bond investors about what has really changed since the Federal Open Market Committee (FOMC) meeting last week,” said Tom Graff, head of fixed income at Brown Advisory.
“Some are arguing that the Fed has lost its nerve after a couple of days of inflation and will eventually not follow through with allowing inflation to stay above 2%.”
The break-even inflation rate on five- and 10-year Treasury inflation-protected securities (TIPS) has fallen nearly 25 basis points since hitting 10- and eight-year peaks in May.
The five-year, five-year forward break-even inflation rate, which tracks the expected rate of inflation over five years’ time, was recently at 2.2%, up from a seven-year high of 2.4 reached in May. was below %. Those measures have improved slightly in recent days.
The personal consumption expenditure price index (PCE) – the Fed’s preferred measure for inflation – rose 3.6% in April from a year earlier.
Wavering Fed?
Last August, the Fed adopted a flexible average inflation target (FAIT) that is designed to be somewhat forgiving of price pressures compared to the past, in line with its dual role of achieving maximum employment and stable prices. A major shift in the approach towards central banks.
Some market participants say the Fed may be less committed to FAIT than it is to adopt policy. the last summer, when Powell said the central bank would allow prices to rise faster than in previous cycles.
Last week’s Fed meeting suggested that “they are running back,” said Michael Pond, head of global inflation research at Barclays.
“We may have some inflation for now, but on a structural basis, this feedback function of the Fed is likely to lead to a persistent undershoot once again,” Pond said.
But not everyone agrees that the Fed’s commitment is wavering.
“I think some people think the Fed is changing the tune and leaving flexible average inflation targeting. I don’t agree, but clearly some people are turning that trade-off,” Graff said.
Fed June meeting
Powell’s argument has been that the rise in inflation this year is transitory and is related to the reopening of an economy crippled by the coronavirus pandemic.
The Fed’s more rigid stance at last week’s meeting surprised some market participants as the bank’s inflation forecasts hadn’t changed dramatically in a few years.
Average Fed Voter PCE in June was expected to rise to 3.4% this year, as against 2.4% in March. The estimates for 2022 and 2023 were 10 basis points higher.
There was clearly no way market participants weighed in on Powell’s every word in his address on Tuesday.
Cathy Bosjanic, chief US financial economist at Oxford Economics, said this week that Powell “emphasised again that he has the tools to reduce inflation.”
“And while I think he was still optimistic about the outlook overall, he said (they) were surprised at how big and persistent it (inflation) was.”
Source: Reuters (Reporting by Kate Duguid, Saqib Iqbal Ahmed and Karen Piog; Editing by Megan Davis and Anna Nicolasi da Costa)
