Inflation the Bubble Killer

If you are looking for a catalyst which could kill the equity market optimism, look no further than the Fed and its management of inflation. Let’s put the pandemic and politics aside because, in the end, the Feds dual mandate demands price stability. If inflation runs to hot the Fed will have to take the “punch bowl” away.

All the warning signs are there for the United States to brace for high inflation – but the inflation itself is nowhere to be seen.

Everything seems to be pointing in the direction of high inflation. Recent economic data has revealed companies are looking to raise prices post-pandemic and pass the increase onto consumers, and tell-tale price moves in the bond market hint that serious investors are anticipating an increase in Consumer Price Inflations (CPI).

However, amid the sound of alarm bells – a CPI increase hasn’t meaningfully occurred in the United States – or any of the other major economies. In fact, with data collected as recently as December 2020, the U.S. showed a modest 1.4% rise for goods and services. Federal Reserve officials asserted that low inflation is potentially more damaging than drastic price increases, as it’s a hallmark of a struggling and stagnant economy.

The US V Shaped recovery is likely to benefit from a much-needed jumpstart with the Biden administration boosting confidence with a $1.9t stimulus spending plan, and engineering a speedy roll-out of the COVID-19 vaccine. Sudden resulting consumer demand will trigger upwards price pressure as companies and businesses attempt to recoup losses sustained during the pandemic.

Currently, the resulting impact on inflation however, is unlikely to change the Fed’s long-standing policy. A moderate increase indicates growth and an economy on the mend. The challenge remains to reach and maintain 2% inflation but not to go much beyond, with stable prices, maximum output and full employment.

The question remains: why are big-money investors jittery while the Fed plays it cool? It’s partly explained by the Fed’s confidence in its adjusted strategy which was introduced in Q3 of 2020. New flexible average inflation targeting is designed to keep interest rates lower for longer, by absorbing the higher level of inflation, even as unemployment makes a recovery, thus steadily stimulating the economy.

The Fed will delay tightening for as long a possible. But if inflation get to high they will have to act.

Chairman Jerome Powell acknowledged that the economy could see some price pressures in the coming months, perhaps from rising energy and also spending of the massive aid that has been necessary to steer the U.S. through the coronavirus crisis. It’s been noted that too much sudden spending will spark temporary but sharp inflation hikes.

Right now the risk of a ‘taper tantrum’ – a fantastic expression coined in 2013 after a panicked surge in U.S. Treasury yields – is low, but that doesn’t mean we shouldn’t remain vigilant. The Fed has openly asserted adjustments will not be made to the central bank’s ultra monetary policy stance, including its massive $120 billion a month bond-buying program, until substantial progress towards its goals of full employment and 2% inflation is evident.

With stocks and risky assets at all-time highs, the reality is that investors seeking a stock market correction need look no further than Central Banks. The adage remains true in our view: bull markets don’t die of old age, but rather they’re killed by the Federal Reserve.

In the past, central gradually raising rates would not trigger panic – especially when other central banks such as the European Central Bank and Band of Japan remain loose. However, the general consensus is that driving interest rates down to zero doesn’t make assets significantly more valuable than they were before. Especially with the pressure on economic activity and earnings to live up today’s expected multiples.

If the bonds markets forward curve is correct, we could expect the Fed and other central banks starting to re-evaluate their monetary policy within nine to 12 months.

Harking back to 2016, savvy investors should watch what the policymakers – including the Fed – do, more closely than what they say.