Inflation will rise and will test the Fed

Hot air balloon

The Federal Reserve accepts that inflation will rise above 2% this year, but the central bank insists this will be temporary and longer-term inflation expectations remain anchored.

To many in the markets the authorities have got away with it. We have just lived through a period of unprecedented peacetime money creation by central banks, with inflation staying below the low target rates the central banks set.

The Federal Reserve (Fed), the Bank of England and the European Central Bank celebrate their success, and assure their followers these large economies have caught some of the Japanese habit of combining deflation, low or no inflation, and aggressive monetary policies. They argue they can keep interest rates around zero, carry on buying-up government bonds to keep longer term rates down, and still struggle to get the average inflation rate up to their required 2%. Current rises in inflation, they tell us, will be temporary.

The US has done much more than other countries as a proportion of its GDP, with money growth twice as fast as the UK or Euro area. There was also a much larger aggregate fiscal stimulus on top. The Fed accepts that this year inflation will rise above 2% but welcomes the move as it wishes to average with previous years when inflation fell short of its target. Fed chairman Jerome Powell has said that as long as inflation expectations about longer-term price rises remain anchored, all will be well.

Financial-asset inflation

If we look around there is much inflation to see, despite the complacent reassurances from the historic official price indices and the statements from the authorities. US inflation figures today should see it well above the 2% target. Bond prices were greatly inflated in recent years by the huge official buying programmes, to leave many of the European bonds so expensive they do not even offer any positive interest payment to holders. Share prices too, particularly in the US, have been bid up to high levels in a form of inflation that the market admires.

More recently, some of the excess cash and borrowings have been finding their way into commodity prices. This year the core commodity price index is up 23% in four months. Oil is up more than a half, as is copper. Wheat is up by 19% and rice by 16%, which is beginning to hit the budgets of those on lower incomes. Steel is up 30% and timber has almost doubled.

These general commodity market prices will now feed into the prices people pay to build and maintain their homes, to feed and clothe themselves and to travel. Baltic freight rates are up a massive 130% this year, affecting the prices of anything which is globally traded.

Wage rises ahead

You would expect some of these price rises to start to shift wages upwards as the US economy recovers from lockdowns. There is evidence that higher unemployment benefits are encouraging people to play hard to get in the jobs market, despite higher unemployment levels brought on by the pandemic.

Meanwhile, the President has clearly indicated he would like to increase the minimum wage to $15 an hour and drive lower wages up sharply. Democrat-led states are pushing up their regional minimum wages, with New York raising it to $12.50 and California to $14 for larger employers. The President is using executive powers to require a $15 rate on all people working on federal contracts from next January, as the Senate may not allow the general rise.

All this implies that the inflation will increase. The general commodity surge coupled with the minimum-wage push points to higher inflation generally in the US. The New York Fed carries out an inflation-expectations poll every month. In March it hit 3.2%. We need to watch these trends and see if the Fed holds its nerve as short-term inflation rises. It may prove to be more than just a few supply shortages of commodities and particular products which can be controlled through more capacity if it spreads more widely to wages, rents and service sector prices.

 

View Article – published by Charles Stanley on 12th May 2021