Fed needs the market to believe in inflation to bring it back

When it comes to inflation, the Federal Reserve is telling the market to expect the unexpected.

Investors don’t foresee consumer price pressures building any time soon. That’s the message from how inflation-linked U.S. government debt is trading and the record-breaking amount that was just yanked out of the iShares TIPS Bond ETF, a fund that holds Treasury InflationProtected Securities.

This is a problem for Fed policymakers trying to fulfill their duty to maintain price stability, because they believe inflation expectations are a leading driver of actual inflation. And sagging inflation increases pressure on the Fed to cut interest rates, something it isn’t inclined to do at the moment.

Minutes from the Fed’s April 30-May 1 meeting, published Wednesday, confirmed that many officials agreed with Chairman Jerome Powell’s description of a recent downdraft in U.S. inflation as “transitory.” But several also flagged “a risk that inflation expectations could become anchored” too low, “a development that could make it more difficult to achieve the 2 percent inflation objective on a sustainable basis over the longer run.”

Because consumer price gains have been lagging the Fed’s 2 percent target for much of the past decade, it’s little wonder that inflation isn’t a hot topic in the market yet. But it may be warming up, with the Fed actively debating how it can meet its inflation goals, including a June 4-5 conference to discuss different approaches.

“These inflation expectations built into the market, the Fed’s going to push back. They’re just too low,” said Thanos Bardas, the global co-head of investment grade at Neuberger Berman, which manages $323 billion in assets.

It’s been argued over the past decade that enduring forces such as aging demographics, technological advances and shifting labor trends have ushered in a new world of low inflation, but a lot is happening right now that could help reshape the outlook. That includes tightening supply in the oil market, rising wages and tariffs.

Lindsay Politi at One River Asset Management is among portfolio managers who believe the market is underestimating price pressures as a result of escalating trade disputes.

Market-implied inflation expectations fell further on news of additional tariffs by the U.S. and China, because investors focused on the tax to consumers, and a threat to the global economy.

Politi is focusing on the likely bump in consumer prices, and a buying opportunity in TIPS.

“For me, what’s most interesting is that the tariff risk is really being priced in only as a growth risk and not as an inflation risk right now,” said Politi, who manages global inflation-linked portfolios.

The June 4-5 conference will be important. Many Fed officials have described it as the centerpiece of the year-long review of monetary policy strategy that is currently underway.