Investors shrug off inflation fears – for now
US inflation is at its highest since 1982. Investors seem unworried – but how long will that last?
The last time US inflation was this high Ronald Reagan was president and Argentina was about to invade the Falkland Islands. US consumer prices rose by an annual 6.8% last month, the fastest pace since March 1982. Petrol prices surged by 58.1% in the year to November. Strip out the effect of volatile food and energy prices and “core” inflation hit 4.9% year-on-year, its highest reading since 1991.
Inflation? What inflation?
Markets were unperturbed, says Randall Forsyth in Barron’s. The pricing of US treasury inflation-protected bonds implies that inflation will come back down over the next year or two. For now, investors still have confidence in the ability of central bankers to get price rises back under control. The big worry for the US Federal Reserve is that expectations of rising prices become “entrenched”, says The Economist. The average US consumer thinks prices will rise at an annual pace of 4.2% over the next three years, according to the Federal Reserve Bank of New York. If they demand higher wages, then these expectations will become a self-fulfilling prophecy.
“In an ideal world” the Fed would be planning to raise record-low interest rates now; instead, it is still adding new liquidity to the market by buying bonds with printed money every month. The Fed should move to “taper” those purchases quickly.
The Fed risks being caught “behind the inflation curve”, says Mohamed El-Erian on Project Syndicate. For months its officials have mischaracterised this year’s surge as “transitory”. It was defensible to blame pandemic distortions when prices first took off this spring, but by the summer it was clear that supply-chain problems and labour shortages were here to stay. Policymakers instead buried their heads in the sand. The later the Fed acts on inflation, “the greater the likelihood that it will have to hit the policy brakes hard, causing market turmoil and unnecessary economic pain”.
Powell is trapped
In the 1980s the Fed only got a handle on inflation by administering “brutal shock treatment”, pushing interest rates above 20%, says Larry Elliott in The Guardian. Under the guidance of Paul Volcker, “the inflation hawks’ hawk”, the Fed presided over “business failures and mass job losses”. The “Volcker shock” accelerated the decline of manufacturing and unleashed a crippling debt crisis in Latin America. Such is the price to be paid when a central bank needs to regain lost inflation credibility. A repeat of that strategy today looks nigh-on impossible. The US economy has become so “financialised” that “Volcker redux” would cause a “monumental financial crisis”. Fed chair Jerome Powell is “trapped… Wall Street has the whip hand these days, not the Federal Reserve”.
“Central bank governors are like wild beasts,” says Ron William in the Halkin Letter. “Given too much freedom, they dominate their territory… Carefully managed in a secure enclosure… they lose the will to live and stare blankly into the far distance.” In 2018, Jerome Powell started his Fed term as a monetary hawk, but now he has been well and truly domesticated.