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Saturday, January 29, 2022

How did the Fed Chairman convince Wall Street investors of his position on inflation?

It appears that Federal Reserve Chairman Jerome Powell and his colleagues have won, convincing investors that the current rise in consumer prices will not continue.

When news broke last Thursday that US inflation had risen to 5% in May for the first time since 2008, yields on the major 10-year Treasuries moved in the opposite direction, dropping to a three-month low of 1.43%.

While bond market metrics edged toward expected inflation, they remained well below this year’s high in May.

That upbeat reaction may be welcome news for Fed officials, ahead of next week’s interest rate meeting. Expectations prevail that officials will stick to a very accommodative monetary stance, in pursuit of the twin goals of maximum employment and average inflation at 2%. They have underestimated the risks that their policy could lead to a large and permanent price overshoot.

US central bankers have been repeating over and over the message that rising inflation will mostly be transitory, the result of temporary bottlenecks as the economy reopens, and low readings when the economy shut down a year ago.

Satisfaction of the markets
“The best, and most effective, thing the Fed has done is that they have remained consistent,” says Peter Yee, director of short-term fixed income and head of credit research at Northern Trust Asset Management, which oversees nearly $1 trillion. Tell them that it is transient.

In support of the Fed’s view, price increases in May were largely driven by categories in which supply or demand has skewed due to the reopening of the economy, from used cars and home furnishings to airline tickets and clothing.

“A lot of the items that have gone up were fleeting, more people in the market now feel comfortable going beyond these things,” Ye explains.

In a report to clients following the release of the May data, JPMorgan economist Daniel Silver agreed that the drivers of higher inflation remain mostly temporary, but added that “some smoothing is underway for price increases beyond these factors as well.” Referring in particular to the increase in rents.

Billionaire investor Stan Druckenmiller said the Fed’s easing measures have calmed investors with a false sense of security and distorted asset prices, adding to CNBC TV in an email: “Right now, the market isn’t talking.”

Federal Reserve officials stressed the importance of expectations when discussing the future of inflation. If people believe that prices are heading sharply upward, they act in ways that help achieve that, so the absence of financial market fears of high prices is undoubtedly comforting, but also limited, Policymakers – and perhaps Federal Deputy Governor Richard Clarida – are well aware that the bond market does not give a completely clear reading of expectations, even among investors, and can be bogged down by volumes traded, liquidity and other issues.

Cash flow
Financial analysts have attributed lower bond yields in recent days in part to investors who had previously bet on a move in the opposite direction covering short positions.

The massive cash flow into the money markets – a fact highlighted by the unprecedented use of the Federal Reserve’s reverse repo agreement – is also a factor likely to support demand for Treasuries. Even at these levels, US government debt provides a greater return than many other alternatives, including sovereign bonds in Japan and Europe.

Clarida, who served as a global strategy advisor at Pacific Investment Management before joining the Fed, is a “strong supporter” of the creation of a new Common Inflation Expectations Index developed by central bank staff.

The index consists of 21 different measures of inflation expectations, including some taken from the bond market, and is published quarterly. On this, Clarida said last month that the index was in line with the Fed’s target of a 2% inflation differential.

Incomplete index
Randall Quarles, the Fed’s other vice chairman, said he’s paying more attention to market surveys of inflation expectations than readings from the bond market.

During a webinar at the Brookings Institution on May 26, Quarles said, “Ultimately, what drives inflation is people’s expectations of what wages they will need. Surveys, not measures based on market conditions.

Next Friday, policy makers will get a new reading of consumption inflation expectations, when the latest survey from the University of Michigan is due. Last month, survey respondents said they expected inflation to average 4.6% in the next 12 months, the highest in a decade, although they did not expect it to remain that high in subsequent years.

“Currently, a psychologically significant growth in inflation is unlikely, but it cannot be entirely ruled out,” Richard Curtin, director of the survey, writes in a report released on May 28.

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