Federal Reserve isn’t fooling anybody on inflation

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Inflation expectations rise and rise while US central bank’s governing body implausibly claims prices are ‘well anchored’ at 2%

US Federal Reserve Board Chairman Jerome Powell arrives to testifiy during a full committee hearing on “Monetary Policy and the State of the Economy” in Washington, DC. Photo: AFP / Brendan Smialowski

NEW YORK – Inflation is “running persistently below” the Federal Reserve’s 2% “long-run goal,” and the Federal Open Market Committee “will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent of time and long-term inflation expectations remain well anchored at 2 percent,” the US central bank’s governing body declared in an April 28 statement.

The Fed isn’t fooling anyone.

The bond market’s measure of expected inflation –the yield difference between ordinary Treasuries and inflation-indexed Treasuries – jumped another tenth of a percent last week to 2.4% and is headed higher.

The Fed lost the anchor for expected inflation sometime last year when it bought US$4 trillion of securities. It continues to hold the bag for a Treasury deficit of $3 to $4 trillion this year, depending on whether Congress approves President Joe Biden’s proposed $2.3 trillion infrastructure bill on top of a $1.9 trillion stimulus earlier this year and an additional $1.8 trillion of helicopter money that the White House offered on April 27.

We’ve hammered on this sore toe for the past month because the biggest problem facing the world economy now—apart from the continued spread of Covid-19—is the most profligate fiscal and money policy in American history.

Inflation becomes self-feeding when investors arrange their portfolios to protect themselves against inflation, and that is precisely what the American public has done during the past year, namely buy houses.

With home prices rising at 12% a year, just below the 2005 peak rate during the great housing bubble, Americans are piling into the asset class which historically has provided the best inflation hedge. Homes were the only asset to appreciate in real terms during the inflation of the 1970s.

The Bureau of Labor Statistics (BLS), to be sure, estimates the inflation rate for shelter at just 1.7% a year. That won’t last long. Apartmentlist.com reports:

“Our national rent index is up by 1.9 percent month-over-month, the largest single month increase ever recorded in our estimates, which began January 2017. For comparison, in the pre-pandemic years of 2018 and 2019, month-over-month rent growth in March was 0.8 percent and 0.7 percent, respectively. This month’s sharp increase breaks a record set just last month when rents jumped by 1.4 percent. In each of the past four months, our national index has not only had positive growth, but has outpaced the average growth of prior years.”

The BLS also says that used car prices are rising at 8% a year when the Manheim Used Car Index shows a 41% gain through March—as we’ve noted in the past.

American families are “feeling the afterburn of inflation,” reports CivicScience. Only a third of American households report no change (32%) or lower prices (2%). Sixty-four percent that they are paying more for the same items (38%) or buying less because prices are higher (27%).

The Fed also isn’t fooling the stock market, which fell modestly on Wednesday. Usually when the Fed declares that it will give the market as much money as it wants, stocks go up. Investors evidently no longer believe that the Fed can keep up the pretense indefinitely.

Stocks are better than bonds in this environment, because at least some large companies can maintain pricing power in an inflationary environment.

The Fed has a tiger by the tail, namely the gigantic US borrowing requirement, and any effort to suppress inflation by raising interest rates or slowing the rate of bond purchases would chase away bond investors when the Fed needs them the most.

So we don’t expect any early tapering of monetary stimulus by the Fed. Investors are watching intently, waiting to run. The best trade now is to short the bond market, for example by buying one of several ETF’s whose price moves inversely with Treasury bond prices.

 

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