Investors are struggling to interpret messages from the Federal Reserve about how hot it is willing to let inflation run before pandemic-era monetary stimulus begins to loosen.
Measures of inflation expectations in the US reached multi-year highs in mid-May, but subsided after comments from some Fed speakers and minutes of a committee meeting in April sounded more frightening. Some investors have interpreted this as policy-makers who have a lower tolerance for inflation than previously estimated.
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The drop in inflation expectations was exacerbated by the central bank’s policy meeting on June 15-16, when the Fed made its forecasts for the first two interest rate hikes in 2023.
Since then, inflation bets have fallen, most likely helped by Fed Chairman Jerome Powell insisting on Tuesday that the bank would not raise interest rates in advance for “fear” that inflation might come.
The mess suggests investors are struggling to understand the sometimes conflicting messages from Fed officials facing the first inflation test under a new flexible average inflation rate approved in 2020. “There is a lot of uncertainty among bond investors about what “That’s just changed since the Federal Open Market Committee (FOMC) met last week,” said Tom Graff, head of fixed income at Brown Advisory.
“Some argue that the Fed has lost its nerve after a few inflation printouts and will eventually not follow through, allowing inflation to remain above 2%.”
Inflation by five- and 10-year securities against public capital inflation (TIPS) has fallen by about 25 basis points since it peaked at 10 and eight in May, respectively.
The five-year, five-year forward rate, which tracks expected inflation for five years to five years, was recently at 2.2 percent, down from a seven-year high of 2.4 percent in May. These measures have recovered slightly in recent days. The Consumer Price Index (PCE) – the Fed’s preferred measure of inflation – rose 3.6 percent in April from a year earlier.
Last August, the Fed adopted a flexible average inflation target (FAIT) designed to be somewhat more forgiving of price pressures than in the past, a major shift in the central bank’s approach to its dual role in achieving maximum employment and fixed prices.
Some market participants say the Fed may be less committed to FAIT than when it adopted the policy last summer, when Powell said the central bank would allow prices to rise faster than they would tolerate. previous cycles. Last week’s Fed meeting suggested they were “walking backwards,” said Michael Pond, head of global research into inflation at Barclays.
“We may have some inflation right now, but on a structural basis, this reaction by the Fed is likely to lead to a persistent setback again,” Pond said.
But not everyone agrees that the Fed’s commitment is unchanged.
“I think some people think the Fed is changing and abandoning the flexible targeting of average inflation. I do not agree, but clearly some people are doing this trade,” Graff said.
Powell’s argument was that this year’s rise in inflation is temporary and is related to the opening of an economy that is closing the coronavirus pandemic.
The Fed’s most chaotic stance at last week’s meeting surprised some market participants because the bank’s inflation forecast for a few years outside had not changed dramatically.
The average Fed voter in June expected the PCE to rise to 3.4% this year, compared with 2.4% in March. Forecasts for 2022 and 2023 were 10 basis points higher.
Market participants, weighing every word from Powell to his address on Tuesday, did not have a clear way.
Kathy Bostjanjic, chief US economist at Oxford Economics, said Powell this week “reiterated that they have the tools to reduce inflation.” “And while I think he was still generally true about the prospects, he said he was (surprised) by how big and persistent he was (inflation).”