Happy “buy a pint and get a haircut” day to anyone who’s also in whichever parts of the UK that applies to (I’m losing track despite having friends and relatives all over). Nice to see that the weather hasn’t lost its sense of humour (for those of you lucky enough to be living in sunnier climes, it’s snowing – not quite for the first time this year but close enough to be ironic).
On the investment side of things, one of the most important aspects of re-opening is what it might mean for inflation. And this week, all eyes will be on one early indicator on that front – US consumer price inflation data due out on Tuesday.
Why the inflation data matters
Among other things that markets will pay close attention to this week is the latest US inflation data, out on Tuesday. The inflation data matters, mostly because of what it might imply for the direction of interest rates from here.
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Investors are worried that if inflation is stronger than expected, then the Federal Reserve – America’s central bank – will have to raise interest rates (or at least stop printing as much money), a bit earlier than expected in order to combat inflation. In turn, that will make debt servicing more expensive.
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Now to be clear, we’re not talking about imminent rate hikes here, we’re talking about the difference between rates being raised in 2023 rather than 2024. But at the moment, there’s a lot of debt around to service, so markets are hyper-sensitive about this stuff.
You might wonder why the market is so twitchy. After all, the US central bank has been bending over backwards to explain to the market that it doesn’t want to raise interest rates. In fact, the Fed has been trying to make it clear that its whole approach to rates has changed.
To get an idea of how the Fed feels right now, Helen Thomas of Blonde Money points out one good recent example. Last month, Lael Brainard – a key member of the Fed’s interest-rate-setting committee – made a speech entitled “Remaining Patient as the Outlook Brightens”.
In it, she noted that “the emphasis on outcomes rather than the outlook corresponds to the shift in our monetary policy approach that suggests policy should be patient rather than pre-emptive at this stage in the recovery.”
What does that mean? In the olden days (before the financial crisis and during Alan Greenspan’s Great Moderation), people used to talk about monetary policy acting with “a lag”. In other words, if you thought inflation was going to be a lot higher in a year’s time, you better act now to stave that off. So the job of a central banker was to form a view on the outlook, then react to that outlook. What Brainard – and by extension, the Fed itself – is saying here, is that they want to see what happens first, and then react to it.
In turn, if you still believe that monetary policy acts with a lag (and perhaps in our increasingly financialised economy, that’s debatable), then this implies that the Fed will allow the economy to "run hot" for a while, just to ensure things are ticking over, before it does anything. In other words, they want to see everyone in a job, and inflation actually rising significantly, before they do anything. And indeed, this is exactly what Jerome Powell, the Fed governor, has been saying for quite some time.
So why won’t markets just calm down about all this? As ever, it’s a bit more complicated than that.
Why you should keep an eye on Amazon
Technically, the Fed just controls short-term interest rates. Longer-term interest rates are normally more driven by market appetite for longer-term debt. That’s not been the case in recent years, when quantitative easing has seen central banks buy a lot of government debt across all maturities. But normally it’s the case.
So if inflation expectations go up a lot – as in, the market expects inflation to rise – then investors will push the yields on long-term bonds higher, which in turn means that bond prices go down. That means long-term interest rates are higher, which represents an increase in the cost of money across the economy.
So talk isn’t enough. And standing still isn’t enough either. A central bank can keep short-term interest rates exactly where they are simply by not doing anything (it’s a bit more complicated than that, but not much more). But that’s not the case for long-term rates. If the Fed wants long-term rates to stay lower, it has to do something, even if it’s just telling markets that it won’t allow rates to go higher than say, 2.5%.
In other words, if the Fed is serious about its change of heart, then it’s going to have to act. It’d be nicer if it could simply achieve what it wants to do via implicit threats (because it’s never comfortable to be explicit about a monetary policy that amounts to picking and choosing winners and losers, which is meant to be the government’s job). But I suspect the market will force it to show its hand, one way or another.
Of course, as far as this week goes, the inflation data could be entirely benign. It might even disappoint. You never know from month to month – data is volatile. If there’s a sense that reflation is faltering or undershooting then that could be just as, if not more, disappointing to markets.
In the last week or so, a bit of steam has gone out of the reflation trade. That’s almost certainly a case of it needing to take a breather. But it’s interesting to see that the big tech stocks – the ones that took the biggest hit when bond yields began to rise – made a strong comeback last week.
Amazon in particular looks like it might be about to break higher from the trading range it’s been stuck in since September last year. This is one I’ll be keeping a close eye on. My gut feeling is that if Amazon can break higher then it’s probably a sign that the market believes that the “Goldilocks” environment – where the economy is neither too hot nor too cold – is going to be around for a while longer, which would also imply the bull market in stocks continuing.
We’ll see what happens tomorrow. Meanwhile, for more discussion of all of these topics, subscribe to MoneyWeek magazine – get your first six issues – plus a beginner’s guide to bitcoin – absolutely free here.
