Don’t Fight the Fed

Fed Chair Jerome Powell has been fighting market expectations that the Fed will be tightening monetary policy sooner rather than later. He has been winning the tug of war with the bond market. If Powell has his way, the recent spread of the variant in the US decreases the odds that the Fed will start tapering its bond purchases sooner rather than later (1).

Figure 1: US Yield Curve Spread 10yr-2yr, Graph from Yardeni Research, Chart Collection for Morning Briefing, (Yardeni Research, July 20, 2021)

The Federal Reserve looks to control inflation by manipulating interest rates. When inflation is too high, the Fed will raise rates to slow economic growth, tightening money supply, thus bringing inflation down. However, the Fed maintains its current position, as noted by Fed Chairman Jerome Powell in his June 16 address,

“Today the Federal Open Market committee kept interest rates near zero and maintained our asset purchases. These measures, along with our strong guidance on interest rates and on our balance sheet, will ensure that monetary policy will continue to deliver powerful support to the economy until the recovery is complete” (2).

The Fed maintains that inflation is transitory, whereby these key figures will level out as the economy continues to reopen. In other words, we are dealing with demand-pull inflation, stemming from demand growing faster than production rates, causing the economy to overheat. Demand-side inflation is typically regarded as healthy growth and instrumental to a stronger economy. Nonetheless, many continue to argue that we are dealing with supply-pull inflation. In order words, the tightening supply of goods and services limits output and forces increased prices.

Consumer Price Index for All Urban Consumers has run red hot in 2021 as the economy reopens. Inflation accelerated at the fastest pace in 13 years, primarily as the recovery from the pandemic gains steam. Consumer demand has driven up prices in nearly every sector of the economy, from autos to airline fares. Even the Fed has been surprised by the rate at which prices have increased. In his June address, Powell explained, “So inflation has come in above expectations over the last few months (3). Nonetheless, he reiterated the Fed’s position, “But if you look behind the headline numbers, you’ll see that the incoming data are…consistent with the view that [the] prices…driving that higher inflation are from categories that are being directly affected by the recovery from the pandemic and the reopening of the economy.”

Figure 2: One-month percent change in CPI for All Urban Consumers (CPI-U), seasonally adjusted, June 2020 – June 2021. Graph from Bureau of Labor Statistics, Consumer Price Index – June 2021, (U.S. Department of Labor, July 13, 2021)

Powell continued the Fed’s stance in a semiannual meeting to Congress on July 14, when he stated, “The high inflation readings are for a small group of goods and services directly tied to the reopening” (4), with the Fed aiming to keep rates near zero until at least 2023.

The Treasury yield is used as the benchmark debt level to price products from mortgages to corporate debt. In response to Powell’s testimony, U.S Treasury yields fell, puzzling many investors who expected them to increase amid increasing inflation. However, the market seems to be signaling that the bond market is following in the steps of Powell in regard to the theory of the current transitory inflation. At the same time, investors seem to be concerned with economic prospects, anticipating a significant growth slowdown. With the reopening of the economy well underway, the spread of the Delta variant only adds to this script.

Figure 3: 10-Year US Treasury Bond Yield, Graph from Yardeni Research, Chart Collection for Morning Briefing, (Yardeni Research, July 20, 2021)

In fact, according to a Bank of America Global Research survey of fund managers taken in early June, 72% believed the spike in inflation was transitory (5). The survey profiled 224 fund managers with a combined $667 billion in assets under management.  

1) Yardeni Research, Inc., July 20, 2021

2,3) Board of Governors of the Federal Reserve System, June 16, 2021

4) Board of Governors of the Federal Reserve System, July 14, 2021

5) Reuters, June 15