Inflation is here
Not so long ago, the perspective of inflation reaching levels above central bank targets was mere fantasy. But in the US this is now reality, forcing the Fed to keep tightening. Something that not all investors seem to have embraced.
US headline inflation rose to 2.9% in June, which is the highest level since February 2012, or more than six years. The current level of inflation is also almost a full percentage point higher than the 2% level the Fed considers in accordance with its definition of stable prices. Core inflation, inflation minus the volatile components food and energy, has climbed back above the 2% threshold as well. And it’s not just oil that has pushed prices higher.
Inflation is not just showing up in consumer prices. In fact, producer prices are up 3.4% year-on-year, a level not seen since 2011, and export prices rose more than 5% in June. And let’s not forget the ISM Manufacturing Prices Index, which too has risen to multi-year highs, indicating higher raw materials prices. All of these indicators show that inflation is abundant right now.
The revival of inflation has set the Fed on a determined path of further rate hikes until 2020. The latest Fed dot plot, which shows the expected appropriate level of the Fed Target Rate for different voting members, shows short-term rates are likely to go up to 3.4%. Currently, the Fed Target rate is at 2.0%.
Markets however do not expect yields to go up to these levels. The assumed neutral level of the Fed rate, the point where monetary policy is not stimulating growth or restraining it, is at 2.9%. A Fed Target Rate significantly higher than the neutral rate thus implies that the Fed expects it has to weaken growth to keep inflation in check. But after more than a decade of extraordinary stimulus and relatively low inflation levels, investors are struggling to believe that rates will go up by so much.
However, with unemployment at record low, wages growth increasing, albeit very, very gradually, inflation above target, and GDP growth expected to reach 2.9% this year and 2.5% next, a Fed Target Rate of 3.4% doesn’t sound that strange. At the same time, 2020 is still a long time away and accidents can happen very quickly. And that was precisely why Fed chief Jerome Powell stated that the Fed will ‘keep gradually raising the federal funds rate, for now’. These cleverly added words at the end reveal the Fed is aware of increasing tensions around the globe and show it’s not on ‘auto pilot’.
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