Jonathan Marriott, Chief Investment Officer
As the global economy reopens, and fiscal and monetary stimulus continues, it is widely expected that inflation will rise. As the economy shut down last year, the oil price fell dramatically and OPEC cut output to contain the glut. Since then the price has recovered to pre-pandemic levels. Annual inflation will reflect the recovery in the second quarter. The oil price has a bigger impact on inflation in the US where the tax element of petrol prices is much lower than in the UK. As the vaccines enable economies to open up, spending will pick up, particularly on holidays and entertainment. As a result, annual inflation will rise but the Federal Reserve (Fed) has indicated they believe these effects are transitory.
Pre-COVID, aging populations, technological innovation, declining demand for oil and globalisation were all forces that kept inflation low, despite historically low unemployment. As we come out of the pandemic with higher unemployment and greater indebtedness, this may add to the deflationary pressures. Continued stimulus and low interest rates for many years in Japan failed to produce any spike in inflation. On balance, we agree with the Fed that inflation will be temporary
This year we have seen US bond yields and inflation expectations rise. Bonds recovered moderately at the start of this week on the hope that speakers from the Fed would counter the sell-off. It was suggested that they could move to flatten the yield curve by buying longer dated bonds. Fed Chair, Jay Powell, speaking on Thursday failed to deliver on this hope.
He reiterated that they expected the rise in inflation to be temporary and that it would take several years to reach their targets of 2% inflation and full employment. President Biden is still pushing through his $1.9 trillion stimulus plan and further spending on infrastructure will follow this. The Fed has already moved to an average inflation target, so they can allow a temporary spike in inflation without raising rates. Consumer demand may pick up post pandemic but a vast amount of spending on services has been lost, and the stimulus has tried to make up for this. However, this is not a permanent boost for the economy. Last year the Fed has expanded its definition of full employment to include disadvantaged minorities which may give them another reason to hold off on interest rate rises. Historically, bond markets price in more rate rises in any cycle that actually occur. US mortgage rates adjust with longer dated bond yields so they will not want to see these rise too far.
Powell noted that they wanted to avoid the mistakes of the 60s and 70s. In the first half of the 60s, the US Consumer Price Index annual rose just 1.2% per annum, but then sharply rose to 5% by the end of the 60s and peaked near 15% in 1980. At this time, the Fed raised the target interest rate to 20% so talk of this will not have helped the mood in the US bond market. Conditions today are very different. The 60s baby boom generation meant we had a rising working age population who had money to spend. There was an oil price shock with OPEC controlling the supply and price. Today we have declining demand for oil and are less dependent on OPEC countries. The internet did not exist making globalisation and price comparison harder. Central Banks around the world now target inflation at 2%. Personal and company indebtedness make interest rate rises more painful and as a result harder to do. Powell's comments indicate that they may be prepared to tighten if inflation gets out of hand, but that is not his, or our, expectation.
The Fed will want avoid an asset price boom and bust so may welcome a gradual adjustment in rate expectations to calm some of the excesses, but not at the expense of significantly tighter financial conditions. Following Powell's comments this week, they appear to be willing to tolerate some steepening of the yield curve, but this attitude may change if the move continues. In any event, we do not expect rates to rise formally for some time
To conclude, given the dip in prices last year and the return to work this year, the annual inflation number will almost certainly rise in the middle of this year. However, we believe this will be temporary. While fiscal stimulus will continue this year, we expect this will not be repeated which will in effect be a fiscal tightening. We therefore see sufficient reason for the Fed to keep official rates low for some time to come.
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