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As the economy speeds up by 2021, investors may have to contend with some unexpected inflationary pressures, even for a short period of time.
Bond market traders and Wall Street experts have signaled an increase in inflation from its current latent levels.
In fact, many see inflation heading to and perhaps slightly above the Federal Reserve’s 2% target rate, which has been evasive for much of the last decade. The main reason is an economic reopening fueled by several vaccinated Americans, which will cause upward price pressure in industries that were held back during the coronavirus pandemic.
However, the trick will be to keep it there.
The Fed believes that some inflation is good for the economy, as it signals growth and allows the central bank’s space to act the next time a crisis arises and calls for monetary policy help. However, a number of factors have conspired to keep inflation low and will probably help curb growth in the coming months.
“We expect interest rates to remain lower for longer and we expect inflation to remain limited,” said Sunitha Thomas, national portfolio advisor at Northern Trust Wealth Management. “We think there will be some volatile footprints on inflation, and the market will react to that and try to decipher what that means. We think it’s more cyclical than permanent.”
At the Fed meeting earlier this month, President Jerome Powell acknowledged that the economy could see some price pressures, perhaps due to rising energy.
However, policymakers should see a sustained level before taking any action, a position now codified according to the Fed’s flexible average inflation targeting approach, which it approved a few months ago.
“It will not be easy for inflation to rise. … It will take some time,” Powell said during his press conference after the meeting. “What we are saying is that we will maintain an extremely accommodative policy until enlargement goes down well. And we will not prevent rates increase until we see that inflation actually reaches 2% and that we are on the right track to exceed 2%. This is a very strong commitment and we believe this is the right place to be. “
The question of rising inflation and the answer to the Fed’s projected policy are key, as the market enters the next phase of a strong recovery that began in late March at pandemic-induced lows.
Investors are increasingly wondering whether the market is entering a bubble phase similar to the collapse of the 2000 dot-com, which was exacerbated by rising interest rates trying to keep pace with growth.
“As we scan the market commentary landscape through 2021, ‘the return of inflation, probably with revenge,’ is a very, very common theme,” Nick Colas, co-founder of DataTrek Research, said in a note this week.
Colas pointed out that 5- and 10-year rates of return, or the difference between government bond yields and treasury inflation-protected securities, are both just a shadow below 2%. This is a maximum of two years and is a measure of where the market sees the consumer price index.
Such an environment, Colas pointed out, is generally not good for inflation-sensitive securities, such as longer-term bonds, “unless it is believed that the market’s enthusiasm for a global economic recovery in 2021 it is deeply displaced ”.
He hopes for a sharp rejection
Goldman Sachs, for example, is at the forefront of the package when it comes to hopes for next year’s economy.
The company’s economic team sees a year-on-year GDP growth of 5.9%, about 2 percentage points ahead of consensus estimates. Along with this growth projection comes the expectation that core inflation, as measured by the Fed’s preferred criterion, the personal consumption spending deflator, will “jump short over 2% next spring as we overcome the weakest effects of pandemic base, “Goldman economists Alec Phillips and David Mericle said in a note.
“Several categories should come from the direct and indirect disinflationary effects of the pandemic, including tariffs, hotels, clothing and financial services,” they added. “But the pandemic has also had temporary inflationary effects in categories such as used cars and medical services, and the full impact of a weaker economy on shelter and other categories of basic services sensitive to weakness has not yet materialized.
The Goldman team said that only a “very tight labor market” would cause a sustained rise in inflation, which would then lead the Fed to raise rates, and this is unlikely soon.
Similarly, Citigroup economists expect inflation to rise above 2% by April and stay there for a few months, but then “set back to the 2% target by the end of the year”. The company sees rapid increases in the prices of clothing and offset clothing by reducing the costs of used car and medical services.
These expectations for a controlled inflation environment help fuel a particularly dynamic outlook on Wall Street for another year of strong profitability.
“All of this has led us to have positive expectations for the reopening of the economy and more confidence in earnings expectations next year. We expect the Fed to remain very accommodative and interest rates to remain lower for more. time, “said Thomas, a trusted advisor. “We look forward to 2021.”