Updated: 02-27-2021

There is no way around it. You will be hearing a lot about inflation in coming months and you will likely be hearing quite a bit about inflation readings that are much higher than what you might have grown accustomed to seeing.

That's because inflation reports will be lapping some soft -- very soft -- price comparisons that were borne out of the pandemic and the associated collapse in demand.

Support Keeps Coming

Unfortunately, the pandemic has not ended but, fortunately, economic activity has picked up sharply from the pandemic lows last spring. Contributing to the pickup in economic activity has been an abundance of fiscal and monetary policy support.

That support is still coming, too. Federal Reserve ("Fed") officials have made it clear that the Fed won't be raising rates anytime soon and that the Fed isn't going to be cutting back on its asset purchases anytime soon. Meanwhile, another fiscal stimulus package will soon get through Congress, likely through the budget reconciliation process, that should be about $1.5 trillion.

Once that measure passes, the combined impact of fiscal and monetary policy support since the start of the pandemic will be equivalent to roughly 40% of nominal GDP.

It's no wonder that breakeven inflation rates are rising. There is a clear belief that this support, and associated flood of liquidity, is going to result in higher prices as pent-up demand chases too few goods and services. The Federal Reserve seems fine with that, too. It wants the inflation rate to run above 2.0% for a time so that it can achieve an average inflation rate of 2.0%.

Well, the market seems to think the Fed will get what it desires.

A High Five

The 5-year breakeven inflation rate, which the Federal Reserve Bank of St. Louis notes implies what market participants expect inflation to be in the next five years, on average, is 2.29%. That's up sharply from the 0.14% rate seen on March 19, 2020. Incidentally, that was right about the time the Federal Reserve started unleashing a slew of monetary policy support programs to keep liquidity flowing and to provide stability to the financial markets. It is the highest five-year breakeven inflation rate in eight years.

The question is, will this 5-year breakeven rate start to level out like it did following the financial crisis? The answer will become known in due time. If the breakeven rate stays on its recent trend, though, the Fed will have its work cut out for it to put the market's inflation expectations back into the stuffy bottle where they have resided for nearly 20 years.

The Fed is sounding quite confident in its handling of matters and blithely unconcerned about high inflation rates sticking. Fed Chair Powell has said more than a few times now that the high inflation rates expected in coming months are likely to be transitory.

That could be a tough sell in the heat of the headline inflation battle in coming months, especially when many commodity prices have already risen appreciably, when the dollar has weakened, and knowing that the extraordinary policy support isn't just a "Fed thing." It's happening the world over.

A Little Vigilante Fit

The Treasury market is sniffing out impending inflation pressures. Some say the recent backup in yields is the manifestation of an early taper tantrum. That is, some think the Fed will be forced to pull back on its asset purchases sooner than it thinks because of the inflation pressure.

We would submit that the backup in yields of late isn't a taper tantrum so much as it is the vestiges of a little bond vigilante fit. Our view is grounded in the understanding that the Fed chair has conceded that there will be some high inflation prints in coming months and that, when they arrive, the Fed will do nothing about it.

With the sizable increase in many commodity prices, and so many companies having a ready excuse to reclaim some pricing power that has been weakened for the better part of two decades, it is understandable that bond vigilantes are feeling somewhat ill at ease with the Fed's complacent inflation outlook.

What It All Means

Fed Chair Powell and his colleagues might think one thing, but it's what the market thinks that will ultimately matter. If the market thinks the Fed is playing a game of inflation chicken that it is destined to lose, inflation expectations will continue to go up and long-term rates will follow assuming the Fed doesn't swoop in with yield curve control measures (more than it already has).

Such efforts might be able to tamp down long-term rates, yet they won't necessarily tamp down price increases themselves. Moreover, the persistence of low, long-term rates has been driving asset inflation, which carries its own set of problems beyond general price inflation.

Coincidentally, Fed Chair Powell hasn't sounded all that concerned about equity valuations either, suggesting high valuations can be rationalized based on low interest rates and an equity risk premium that favors owning stocks over bonds. The corollary is that rising interest rates will increasingly become a problem for stocks, and a market, sporting a high valuation.

The Fed, then, better be right with its inflation view, and more importantly, better be able to convince the market that high inflation prints in coming months will be temporary.

There is a lot of pent-up spending potential out there and there is presumably a lot of pent-up desire on the part of businesses to reclaim some pricing power. Aside from that, there is a knowingness that trillions of reasons are circulating -- and trillions more soon will be -- to doubt the Fed's assumptions. Those doubts are emerging in the market's rising inflation expectations.

--Patrick J. O'Hare, Briefing.com

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