Why it may not be plain sailing for Fed on inflation

MARKETS reached the half-year point last week, with Wall Street equities reaching new highs, the US 10-year bond yield steady slightly below 1.5 per cent and the greenback improving. Investors shrugged off concerns about “tapering” by the US Federal Reserve and analysts hailed the latest US employment data as a “goldilocks” moment that showed that the economy was running “not too hot, not too cold, but just right”.

This current benign perspective at the middle of the year re ects the recent big improvement in growth prospects as a result of successful vaccine campaigns, with a number of major central banks having raised their growth forecasts in the past few weeks.

More importantly, markets appear to be buying into the Fed’s argument that any accompanying ination will be “transitory”, meaning that quantitative easing tapering will not be seen for some time and interest rates will be left alone for even longer.

The latest US June employment reports provided encouragement to this view. Although 50,000 new jobs were added, which was more than markets expected, other crucial components of the data were a little softer. The unemployment rate ticked up to 5.9 per cent and the workweek dropped.

This leaves a weaker June path for economic activity than assumed, with growth forecasts for the second quarter being adjusted slightly lower. And although wages growth at 3.6 per cent year on year was a bit stronger than assumed in June, they were revised slightly lower for May and April.

Overall, the numbers thereby reinforced investors’ belief that the Fed will remain dovish, causing bond yields to ease and equities to rally further into the end of the week.

However, it may not be as plain sailing for the Fed on in ation, as the markets currently assume, on a number of fronts, including wages where there are widespread indications that pressures are building due to strong demand for labour and high vacancy rates.

While the markets appear to be buying the Fed’s view that current high readings of in ation are being driven by one-off exceptional factors in the consumer goods sector in particular, such as a postpandemic dislocation of supply chains, wages are among a number of other elements that could yet tip over into broader price pressures.

Rising asset prices, house prices and oil prices are other ingredients that could all feed into a much more troubling challenge in the months ahead.

Mohammed El-Erian, president of Queens’ College, Cambridge University, writing in the Financial Times last week took issue with the benign “goldilocks” assumptions that currently prevail, arguing that too much confidence is being placed in the view that in ation will be “transitory”, along with some other assumptions “about the durability of high global growth rates and the continuation of ever friendly central banks”.

In warning that there has been too little appreciation of the way in ation can develop through the system, he went on to express concern that the Fed could be very late in adapting its strategy should price pressures become more persistent.