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As the economy picks up speed in 2021, investors may have to contend with some unexpected inflationary pressures, even for a short time.
Bond market brokers and Wall Street experts have signaled an increase in inflation from its current latent levels.
In fact, many see inflation approaching and perhaps slightly above the Federal Reserve’s 2% target, which has been elusive for much of the past decade. The main driver is an economic reopening fueled by more Americans being vaccinated, which will put upward pressure on prices in industries that were held back during the coronavirus pandemic.
The trick, however, will be to keep it there.
The Fed considers some inflation to be good for the economy, as it signals growth and gives the central bank room to act the next time a crisis occurs and to require monetary policy assistance. However, several factors have conspired to keep inflation low and are likely to help stem the increase in the coming months.
“We expect interest rates to be lower for longer and inflation to remain contained,” said Sunitha Thomas, national portfolio consultant at Northern Trust Wealth Management. “We think there will be some volatile impressions about inflation coming in, and the market will react to that and try to figure out what that means. We think it is more cyclical than permanent.”
At the Fed meeting earlier this month, President Jerome Powell acknowledged that the economy may experience some pressure on prices, perhaps due to increased energy.
However, policymakers would have to see a sustained level before taking any action, a stance now codified under the Fed’s flexible average inflation targeting approach, which was approved a few months ago.
“It won’t be easy to get inflation up. … It will take some time,” Powell said during his post-meeting press conference. “What we are saying is that we are going to keep the policy highly accommodating until the expansion is well underway. And we are not going to raise rates preventively until we see inflation really reaching 2% and being on track to exceed 2%. It is a commitment very strong and we think it’s the right place to be. “
The issue of rising inflation and the Fed’s expected policy response are critical as the market enters the next phase of a strong recovery that began with the pandemic-induced casualties in late March.
Increasingly, investors are wondering whether the market is entering a bubble phase similar to the collapse of the dot-coms of 2000, which was exacerbated by rising interest rates that were trying to keep up with growth.
“As we examine the landscape of market commentary in 2021, ‘the return of inflation, perhaps with a vengeance’ is a very, very common issue,” said Nick Colas, co-founder of DataTrek Research, in a note this week.
Colas pointed out that the 5-year and 10-year equilibrium rates, or the difference between government bond yields and inflation-protected government bonds, are just under 2%. This represents the two-year highs and is a measure of where the market sees the consumer price index.
Such an environment, Colas noted, is generally not good for inflation-sensitive bonds, such as longer-term bonds, “unless the market’s enthusiasm for a global economic recovery in 2021 is believed to be profoundly displaced.”
Hope for a sharp recovery
Goldman Sachs, for example, is ahead of the group when it comes to expectations for the economy next year.
The company’s economic team predicts GDP growth for the entire year of 5.9%, about 2 percentage points ahead of consensus estimates. Along with this growth projection comes the expectation that the core inflation measured by the Fed’s preferred parameter, the personal consumption expenditure deflator, “will soon jump above 2% next spring, as we overcome the base effects. of the weakest pandemic, “Goldman economists Alec Phillips and David Mericle said in a note.
“Several categories are expected to recover from the direct and indirect disinflationary effects of the pandemic, including airline tickets, hotels, clothing and financial services,” they added. “But the pandemic has also had temporary inflationary effects in categories such as used cars and medical services, and the full impact of a weaker economy on shelters and other categories of essential slack-sensitive services has probably not yet materialized.”
Goldman’s team said that only a “very tight labor market” would cause a sustainable inflationary boost that would prompt the Fed to raise rates, which is not likely any time soon.
Likewise, Citigroup economists expect inflation to rise to more than 2% until April and remain there for several months, but then “stabilize at the 2% target until the end of the year”. The company sees rapid jumps in travel and clothing prices offset by reduced costs for used cars and medical services.
These expectations of a controlled inflation environment are helping to feed a very bright prospect on Wall Street for yet another year of strong returns.
“All of this has led us to have positive expectations about the reopening of the economy and more confidence about earnings expectations next year. We expect the Fed to be very accommodating and interest rates to stay lower for longer,” said Thomas , Northern Trusted advisor. “We are looking forward to 2021.”