The Fed comes clean and admits that inflation is not transitory

3 mins. to read
The Fed comes clean and admits that inflation is not transitory

Monetary policy is finally being tightened, but the markets are not pricing in the full extent of the measures needed to get inflation back under control.

Jerome Powell, the chair of the Federal Reserve, recently admitted that inflation will linger and that it was ‘time to retire the word transitory’. This effectively brings to an end the debate that has dominated the markets for much of the year and heralds in a new and challenging environment for investors in 2022.

We have already started to see the change in central bank policy begin to take shape. The key part of this was the announcement last week that the Fed will wind down its bond buying program, which is designed to lower long-term interest rates, quicker than previously suggested.

Fed officials also forecast that they will raise short-term rates faster than had been expected with three rate hikes likely in 2022. This decision was really forced on them when November’s US CPI data came in at a 39-year high of 6.8%.

The UK follows suit

It is a similar picture in the UK where CPI inflation is 5.1%, the highest it has been for a decade, with a further increase to six percent expected by the spring. This surge in prices way above their two percent target prompted the Bank of England to increase interest rates from 0.1% to 0.25% last week.

The first hike will only have a marginal impact on borrowing costs and the economy, but a second increase to 0.5% could be a lot more significant as that is the hurdle rate the bank has set for naturally reducing its £895bn holdings of government bonds as they mature. Not re-investing the proceeds in further purchases would effectively reduce the stimulus still further.

There was an interesting update on all this from the Ruffer Investment Company (LON: RICA) in their latest monthly release. These are always worth reading regardless of whether you invest in the fund because of their multi-asset perspective and excellent track record navigating all market conditions.

Taper tantrum on the way

In their view: “This shift is a material change and marks the beginning of a new market dynamic. We have moved from a question of whether inflation is transitory to whether central banks have the willingness and the ability to bring this lingering, sticky inflation back down.”

“If the necessary willingness exists, then we are entering a much more difficult backdrop for markets. The tailwind of gargantuan liquidity injections, which have powered them higher, will now become a headwind.”

The combination of strong economic fundamentals and a need to tackle inflation will see central banks try to slow price rises through tighter financial conditions. This makes equity and credit markets as vulnerable as they have been since the market falls of March 2020.

Happy New Year?

Of course the other big unknown at the moment is omicron and whether the UK government will feel obliged to introduce more restrictions, which would naturally dampen economic activity. America is a few weeks behind us in terms of the spread of the new variant but will no doubt experience a similar dilemma in January.

The good news is that the experience in South Africa suggests that although it is much more transmissible than the earlier forms, it is less likely to cause severe disease, so let’s hope that’s how it turns out over here as well. If it does then the worst of the pandemic could be behind us towards the end of the first quarter and attention shift back to more mundane matters like inflation.

Governments in the US, UK, Europe and elsewhere have injected huge amounts of stimulus in recent years and this is now finally feeding through into uncomfortably higher prices. The central banks have been forced to take the first steps in the tightening process, but I don’t think that the equity or bond markets are anywhere near to pricing in the likely scale of it, which makes a market correction a distinct possibility.

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