4 truths about inflation and the Federal Reserve


Kristina Hooper, Chief Global Market Strategist, Invesco

Inflation is an inescapable topic for investors right now. Consumer price index reports and Federal Reserve comments are scrutinized for clues about what may come next. In this heightened environment, it’s important to remind investors of four truths surrounding inflation and the Fed.

 

1. The Fed is patient and accommodative

Just because the Fed reacts negatively or says it’s surprised by one or more inflation data points doesn’t mean it’s going to tighten monetary policy at its next meeting. Remember, the Fed’s new catch phrase is “patiently accommodative.” In other words, the Fed is going to err on the side of accommodation and is likely to deliberate extensively before tightening monetary policy.

Because it is utilizing multiple policy tools, the Fed also has a sequence in mind to eventually tighten monetary policy. It will start by tapering its asset purchases — which has not happened yet — and then there will likely be a significant lag before it begins to raise rates.

 

2. The Fed anticipates a spike in inflation as the economy re-opens

Time and again, Fed Chair Jay Powell and other Fed officials have telegraphed that a spike in inflation is likely — and acceptable — as the United States economy re-opens and we see the impact of supply chain disruptions and “base effects.” In other words, the comparisons to a year ago are distorted, given what poor shape the economy was in last spring as the pandemic took hold.

 

3. The Fed believes the rise in inflation is temporary

Here’s a critical question from investors: Are inflation pressures temporary, or will they stick around for a while? Powell has reiterated the Fed believes this rise in inflation is temporary. In the June Federal Open Market Committee meeting minutes and its semi-annual report to Congress, the Fed continues to describe higher inflation as “transitory.”

The public appears to agree. University of Michigan consumer inflation expectations for the year ahead dropped from 4.6% in May to a still-high 4.2% in June.1 However, inflation expectations for five years ahead fell from 3% in May to a far-more tame 2.8% in June.1

There is good reason to believe the rise in inflation is temporary. We are at an extraordinary time for the American economy. After being shut down for an extensive period, the economy has re-opened amid pent-up demand and elevated household savings to be spent. There is currently a mismatch between supply and demand, which can drive up prices. However, these are likely to create only temporary inflation pressures. At a certain point, we expect spending to normalize as people adjust and resume a more normal, pre-pandemic life.

 

4. The Fed’s inflation-targeting policy is a paradigm shift

With its current policy, called average inflation targeting (AIT), the Fed is willing to tolerate inflation that modestly overshoots its 2% target before considering tightening. This enables the Fed to be far more flexible and essentially tolerate economic overheating — a distinct pivot from past strategy.

Investors are also wondering what could make inflation persist, such as wage increases. However, we have not yet seen a dramatic rise in average hourly earnings in the U.S., and it seems unlikely that will happen quickly given substantial labor market slack.

A significant increase in money supply can also spur persistent inflation. And while we have seen a surge in the money supply, one other key ingredient is usually present as well: a significant increase in the velocity of money (the frequency at which money changes hands to purchase goods and services), which we haven’t yet seen. But even if a money supply increase were enough to sustain inflation, this would not happen immediately. Rather, it usually occurs with an 18- to 24-month lag, suggesting we wouldn’t likely see it until late 2021 or early 2022.

 

What does this mean for investors?

Persistently high inflation is not anticipated, but it is a risk to consider since it can negatively impact some asset classes. In that scenario, investors could benefit from exposure to commodities (including gold), cyclical stocks, inflation-protected securities, emerging-market assets and dividend-paying stocks as part of a diversified, long-term investment portfolio.