Investors should beware the Ides of March. Federal Reserve (Fed) policymakers have recently been trying to convince market participants that any uptick in inflation from massive fiscal and monetary policy stimulus will be temporary. And that rapidly rising interest rates shouldn’t be feared, but rather celebrated because they demonstrate investors’ confidence that the economy will be booming this summer as COVID-19 vaccinations rise and the pandemic fades.
The mid-March Federal Open Market Committee meeting, Chairman Powell’s post meeting press conference and the Fed’s Summary of Economic Projections all downplayed the risks of rising inflation. Fed officials did raise their 2021 median inflation forecast from 1.8% in December to 2.4% in March. Easy year-over-year comparisons are likely to result in greater measures of inflation, but that’s more about the math than the economics. Despite the 2021 increase, the Fed’s inflation forecasts over the next couple years has barely nudged higher. This underscores the Fed’s expectation that any pickup in inflation will be temporary.
Less than a week after the Fed’s March meeting, Chairman Powell gave an encore performance, this time it was a duet with Treasury Secretary Janet Yellen. Both policymakers sang a similar tune, telling members of Congress not to worry about accelerating interest rates and soaring inflation expectations. Powell and Yellen are required to appear before the House Financial Services and Senate Banking Committees quarterly in accordance with the Coronavirus Aid, Relief, and Economic Security (CARES) Act.
So far, the inflation data is cooperating. On March 26, the Bureau of Economic Analysis reported that the Personal Consumption Expenditures Index excluding volatile food and energy prices (the Fed’s preferred inflation measure) rose just 1.4% over the last 12-months. That figure was below consensus expectations.
Market participants are buying into the Fed’s narrative about transitory inflation too. Investors’ inflation expectations can be observed in Treasury markets by calculating the difference between the yields on ordinary Treasurys and the yields on Treasury Inflation-protected Securities (TIPS) to arrive at the break-even rate. Not surprisingly, the economic recovery has pushed break-even rates to their highest levels in more than a decade, implying that inflation is set to increase. However, shorter-term break-even rates are now higher than longer-term ones — leading to the rare inversion of the break-even curve. That suggests a spike in inflation that then fades away, consistent with the Fed’s expectations.
But what happens if the inflation watchdog (the Fed) has developed a blind spot for a more permanent rise in inflation? Let’s find out.
Figure 1: Rising Inflation Expectations Have Lifted 10-year Yields and Steepened the Curve
Inflationary Powder Keg
Extraordinary fiscal and monetary policies have stoked investors’ inflation expectations. There has been an incredible $4.2 trillion increase in the money supply over the past year. M2, a measure of monetary supply that includes currency, deposits and shares in retail money market mutual funds climbed 27% in 20201. As more Americans get vaccinated and COVID-19 restrictions are rolled back, these elevated savings could be unleashed to create an inflationary boom as early as this summer.
Already, companies have started to warn investors about the negative impacts on profit margins from supply chain bottlenecks, rising raw material costs and higher labor expenses. For the first time since July 2019, the producer-price index (PPI) is outpacing the consumer-price index (CPI), highlighting the increasing pricing pressures that many businesses now face. The gap between PPI and CPI also suggests that, so far, businesses are absorbing the higher costs instead of passing them on to their customers. This supports the Fed’s claim that inflation will be transitory. However, if corporate executives determine that their increased costs are becoming more permanent, they will begin to pass them along to customers, making the spread between PPI and CPI a critical barometer for deciding whether higher inflation is here to stay.
It might be easy for the Fed to dismiss rising prices as transient, but with aluminum, copper, oil, lumber and housing all surging in recent months, it’s risky for investors to ignore the possibility that this may be a more permanent upward shift in prices. Perhaps further fanning the inflation flames, President Joe Biden is expected to unveil his two-part government spending program in the coming weeks with an expected total cost of more than $3 trillion.
Figure 2: Rising Inflation Expectations Have Lifted 10-Year Yields and Steepened the Curve
When Does Temporary Become Permanent?
The Fed isn’t worried about inflation – and that should make investors nervous. After all it’s the Fed’s job to keep prices stable. Yet, brushing aside the early warning signs, Fed officials have hastily concluded that building inflationary pressures are only temporary. But how does the Fed know that price increases are fleeting?
Corporations don’t seem convinced that prices will decrease as production of raw materials increases. The Atlanta Federal Reserve Bank’s March report showed that businesses’ year-ahead inflation expectations jumped to 2.4%, the highest reading since the survey began in 2011. Some market participants also expect greater inflation than the Fed does; the Minneapolis Fed recently reported that traders set the odds at 30% for the CPI to exceed 3% over the next five years.2
Consumers also seem to be anticipating more prolonged price increases. According to the University of Michigan, inflation expectations rose to the highest level since May 2015 among those 55 and older, the group that accounts for roughly 40% of total US consumer spending.3
This month, investors have been on edge regarding resurgent inflation. Rising inflation eats away at the interest bonds pay and cuts into the present value of companies’ future cash flows. The US 10-year Treasury yield is near its highest level in 14 months, pre-dating the pandemic. And, the tech-heavy Nasdaq Composite is roughly 6% below its all-time high reached in mid-February. Longer term, a higher inflationary regime could upend what has worked well in investment portfolios over the past decade, specifically long-maturity bonds and growth stocks.
Sure, the Fed could be correct. Maybe inflation will be temporary and tolerable. However, not preparing for the possibility that the Fed could be wrong seems increasingly risky. Today’s uncertain inflationary environment challenges investors to rethink their asset allocation decisions for both stocks and bonds. To guard against the possibility of rising inflation, investors could consider replacing traditional bonds and growth stocks with growth-sensitive bonds and rate-sensitive stocks to ensure portfolios remain diversified and meet their investment objectives.
1Lisa Beifuss, “Why- and How- Investors Should Gird for Inflation Risk,” Barron’s, March 29, 2021. 2 Lisa Beifuss, “Why- and How- Investors Should Gird for Inflation Risk,” Barron’s, March 29, 2021. 3 Lisa Beifuss, “Why- and How- Investors Should Gird for Inflation Risk,” Barron’s, March 29, 2021.
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