Rising inflation puts central banks’ credibility at stake

The US Federal Reserve is still hoping inflation will go away by itself

(Image credit: © Getty Images/iStock)

The US Federal Reserve is “running out of excuses” for high inflation, says James Mackintosh in The Wall Street Journal. US consumer prices rose by 6.2% year-on-year in October, the fastest rate since 1990. Core inflation, which excludes volatile food and energy prices, hit an annual 4.6%, the highest since 1991.

Bonds swoon

“I expect lots of eyeballs were bulging out of their sockets when they saw the number come in,” Seema Shah of Principal Global Investors told the BBC. Higher interest rates were not expected “before late 2022”, but the Fed now faces pressure to act sooner.

The inflation figure triggered a bond sell-off, with yields on two-year US Treasury bonds soaring “by the most since the market turbulence of March 2020”, say Kate Duguid and Naomi Rovnick in the Financial Times.

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Investors appear to be betting that the Fed will have to tighten monetary policy sooner than expected. Market inflation expectations, measured by the ten-year break-even rate (the gap between yields on conventional bonds and inflation-protected ones), are at their highest level since 2006.

Stocks shrugged off the inflation news and continued to climb, says Jacob Sonenshine in Barron’s. One reason is that corporate profits have so far proven robust. Companies have been able to pass on price rises to consumers without losing sales.

Secondly, while bond yields have climbed, they are still well below the rate of inflation. With returns on bonds so dismal, investors have little choice but to keep pumping cash into the stockmarket.

Not so transitory after all

There has been a fierce debate this year between those arguing that inflation is transitory and those who see it as a more persistent threat, says The Economist. Central banks are in the former camp. They argue that pandemic-induced supply-chain problems will right themselves in time, and that tighter monetary policy will not solve problems such as energy shortages: US petrol prices were up by 50% over the past year.

But inflation has not ebbed. Indeed, the 4.6% rise in “core” prices suggests that inflationary pressures are spreading. Rising rents and wages in America threaten a “feedback loop” in 2022 as “higher salaries beget higher inflation”.

First, Fed policymakers said that “raging inflation” was just “catch-up for the deflation of last spring”, but prices are now high even compared to pre-pandemic levels, says Mackintosh. Then they said that it was caused by “a narrow set of Covid-19-disrupted supply chains”, such as semiconductors. Wrong again. Take away the “excuses” and the Fed’s policy amounts to “hope that inflation will go away by itself” next year. For now, investors are giving it the benefit of the doubt.

That might not last, says Liam Halligan in The Daily Telegraph. “Leading central banks stand or fall on their credibility”, but they are playing fast and loose with it: witness the Bank of England signalling a November rate rise that then didn’t materialise. If central banks lose the trust of markets, traders will “rebel, ignoring future signals, lurching through peaks and troughs, causing financial chao

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Alex is an investment writer who has been contributing to MoneyWeek since 2015. He has been the magazine’s markets editor since 2019.

Alex has a passion for demystifying the often arcane world of finance for a general readership. While financial media tends to focus compulsively on the latest trend, the best opportunities can lie forgotten elsewhere.

He is especially interested in European equities – where his fluent French helps him to cover the continent’s largest bourse – and emerging markets, where his experience living in Beijing, and conversational Chinese, prove useful.

Hailing from Leeds, he studied Philosophy, Politics and Economics at the University of Oxford. He also holds a Master of Public Health from the University of Manchester.