The Federal Reserve wants inflation to run hot, but a sudden, recent rise in U.S. government bond yields and inflation expectations shows that some investors are worried about getting burned.
Inflation is expected to rise in the next few months as last spring's lows roll off year-over-year calculations and pent-up consumer demand is likely unleashed. But the bigger question facing bond markets is whether the inflation rebound will stick or will be little more than a blip.
"The market's still trying to figure [this] out, myself included," said Dominic Nolan, senior managing director at Pacific Asset Management, the asset management arm of Pacific Life Insurance Co., in an interview. Pacific Asset Management has $18.5 billion under management through its affiliates and subsidiaries, according to its website.
The government bond market has seen volatile trading as hopes of a sharp economic rebound grow, with yields on the benchmark 10-year Treasury jumping above 1.5% on Feb. 25 and again on March 4. The yield was trading above 1.6% early March 5 following the release of a stronger-than-expected U.S. jobs report.
Right now, the bond market moves are more reflective of brighter economic prospects moving interest rates further from rock-bottom rather than inflation worries. But bond market inflation expectations have climbed in 2021 and "inflation fears are unnerving investors," wrote Tom Essaye, a trader and founder of The Sevens Report, a financial research firm. Stock markets have fallen from record highs partly due to those concerns, with tech stocks hit hardest as investors sour on their valuations in a rising interest-rate period.
The five-year breakeven inflation rate, a rough measure of the bond market's view of inflation over the next five years, closed on March 3 at 2.45%, its highest level since July 2008. The 10-year breakeven inflation rate closed on March 3 at 2.21%, its highest since August 2014. But it is substantially below the five-year breakeven rate, suggesting investors see some of the near-term inflation pressures subsiding later on.
That would be consistent with the current view at the Fed, which sees a temporary burst in inflation but does not expect it to be sustained.
"People would need to believe that larger increases in prices would be repeated year after year, and we think it's unlikely that these deeply ingrained low inflation expectations suddenly change," Fed Chairman Jerome Powell said during a March 4 event held by The Wall Street Journal, adding the Fed "will be patient" in removing its low-interest-rate policies if inflation expectations remain steady.
If inflation expectations move up too quickly, Fed officials feel "they have the tools" to bring them back down by the usual method of raising interest rates, said Rubeela Farooqi, chief U.S. economist at High Frequency Economics, in an interview.
But the Fed has signaled it will look past any temporary inflation increases and would actually welcome hotter inflation after years of mostly underperforming its 2% target.
"It's really too-low inflation that they have a problem with," Farooqi said.
The central bank made a historic change to its monetary policy framework in August 2020 largely to address that concern. It is now explicitly aiming for inflation to jump moderately above 2% for some time to roughly average out the time it has spent below the target. The Fed has also said it will keep its benchmark rate at effectively 0% until it sees a "broad-based and inclusive" job market recovery, along with inflation reaching 2% and being on track to moderately overshoot it. The central bank has also indicated it will keep buying $120 billion in bonds each month until it sees "substantial further progress" on those goals.
The price index for core personal consumption expenditures, or core PCE, which strips out food and energy prices and is the Fed's preferred inflation measure, rose by 1.5% year over year in January. Inflation plummeted in 2020 as spending on everything from hotel rooms to gasoline dove on limited demand during the pandemic.
Oxford Economics is forecasting inflation will reach 2.35% from the fourth quarter of 2020 to the fourth quarter of 2021, but that inflation subsequently will cool, increasing by only 1.98% from the fourth quarter of 2021 to the fourth quarter of 2022.
"While 'warm' inflation may feel 'hot' following a decade of sub-2% inflation in the wake of the financial crisis, broad-based overheating isn't likely," wrote Gregory Daco, chief U.S. economist with Oxford Economics, in a March 2 note. "We expect the Fed will look through transitory inflationary pressures and focus on achieving a 'broad and inclusive' labor market recovery before removing accommodation."
Some analysts, however, say the Fed may be understating the inflation rebound and could be forced to tighten policy quicker than it expects.
Once the virus is under control, the U.S. economy is "primed for a rebound" that will be far quicker than the sluggish recovery following the 2007-09 financial crisis, according to Sonal Desai, chief investment officer at Franklin Templeton Fixed Income. Fiscal support has put households in much better shape this time, with many saving unprecedented amounts of money and "eager to go back to normal spending habits," she wrote in a research note. The U.S. personal savings rate leaped up to 20.5% in January, up from 7.6% a year earlier.
Supply shortages and the ongoing recovery are also pushing up prices on a wide variety of commodities and products, such as oil, copper and semiconductors, Desai wrote.
Central bankers seem confident that inflation expectations will stay subdued and that they can control "the devil they know" through interest rate hikes that tamp down inflation, Desai wrote. But assuming that inflation expectations will remain anchored at about 2% "could be unduly optimistic" as prices begin rising, Desai added.
Goldman Sachs forecasts core PCE inflation to peak at 2.4% in April, when compared to April 2020 when many lockdown measures were in place. Goldman forecasts inflation will end this year at 2%, but as Jan Hatzius, the investment bank's chief economist, noted in a March 2 report, there could be a lot more room for inflation to grow.
"How high could core inflation go if mass vaccination unleashes surging demand in virus-sensitive categories?" Hatzius asked.
But Nolan, of Pacific Asset Management, said longer-run disinflationary pressures are "dramatically underestimated." That includes the "unstoppable force" of technological advances and automation, which the COVID-19 pandemic could fuel further as employers find new ways to replace workers. The U.S. and other developed nations still have aging populations, which make their economies less dynamic, Nolan added.
Investors are continuing to digest how the Fed's new inflation tolerance will play out, including how much the Fed will allow inflation to rise above the 2% before starting to tamp it down.
"The balance is severity versus duration," Peter Cecchini, CEO and founder of AlphaOmega Advisors, said in an interview. "Would the Fed tolerate a quarter of 3% inflation? I think so. Would it tolerate three quarters of 3% inflation? Maybe. One quarter of 5%? I doubt it."