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June 23, 2021
  • Unpicking the Fed’s more hawkish inflation outlook
  • Partial reversal in reflation trade outperformance

Our special focus this week is: Unpicking the Fed’s updated inflation outlook

Inflation has been on the tip of investors’ and commentators’ tongues, this newsletter’s included, since the back end of last year. With concerns growing among inflation hawks, all eyes were on last week’s eagerly anticipated FOMC meeting for a change of direction by Jay Powell. It didn’t disappoint.

As expected, projections for the Fed’s 1st rate hike were brought forward from 2024 to 2023. The Fed’s outlook for PCE inflation (its preferred measure) this year has been raised a full percentage point from 2.4% to 3.4%. Such a sharp revision upwards is unusual, to say the least, and a clear acknowledgement by the Fed that inflation pressure is building.Growth forecasts for 2021 were also revised upwards to 7% from 6.5% as the economy bounces back strongly from its pandemic-induced stupor.

Powell’s relatively more ‘hawkish’ stance received a jittery reaction from markets. What is visible in the forecasts for 2022 and 2023 (2.1% and 2.2% respectively – only marginal revisions upwards from the March meeting) is that the Fed continues to expect inflation to flatten out in the coming years and fall back into longer-term trends. In other words, the Fed still believes this year’s inflation spike will be a relatively temporary phenomenon. Appearing before Congress this week, Powell calmed markets by re-emphasising his commitment to supporting the US recovery and not raising rates too quickly.

Indeed, there is still no talk of tapering yet. But as the dot plot above shows, seven members are already expecting interest rate hikes next year – not yet a majority of members of course, but indicative of a building expectation of rate hikes. Typically, tapering takes place a year before rate hikes. With rate hikes likely to occur in 2023, talks over tapering will surely ramp up towards the end of the year in preparation for 2022.

Either way, this newsletter will keep a close eye on inflation and the different components driving it. CPI inflation jumped 5% in May (up from 4.2% in April), in part due to low base effects from last year’s deflationary environment. Commodity prices and, more recently, travel activities have recorded particularly strong increases, with transportation-related prices up 3.2% month-on-month in May, a 20% increase year-on-year. Most forecasters expect these pressures to ease – commodities are already softening – and thus their impact on inflation to peter out at some point.

A far more important element for inflation watchers to monitor is wages. So far, wage growth remains under control, with weekly wage inflation at 4.5% year-on-year, despite record job vacancies and small businesses in particular complaining about shortages of skilled labour. The phasing-out of generous unemployment benefits (most likely in September) should see more workers re-entering the workforce, potentially easing upward pressure on wages.

For the moment, the Fed and the markets seem to agree that inflation is under control and this year’s spike will be transitory: we’re not headed back to the 1970s. But one suspects many watchers will be waiting to see how future FOMC meetings pan out, before their fears of a return to stubbornly high inflation (and flared trousers) are completely dispelled.

China’s commodity inflation to retreat, while house prices remain warm

Chinese policymakers have expressed mounting concerns in recent weeks over soaring commodity prices, which threaten to put pressure on businesses. But restrictions on commodity trading and releases of inventories by the government, combined with M1 growth in dollar terms appearing to have peaked, should ease pressure on commodity prices going forward. Another element of some concern to the government is house prices, which remain elevated – rising 0.52% in May month-on-month, after a 0.48% rise in April.

Fed upgrades inflation and growth forecasts, as jobless claims rise

As we discuss above, the FOMC has upgraded its growth and inflation forecasts, mainly for 2021, but continues to view inflation as a transitory phenomenon. Powell made no announcements on tapering, keeping monthly bond purchases at USD 120bn. Elsewhere, June initial jobless claims surprised on the upside with 412k new claims, up from 375k in May and above the consensus of 360k. It’s clearly too early to tell whether we’re witnessing a change in trend, but the health of the US labour market is one to watch – particularly given two-thirds of inflation is composed of wage increases.

In Switzerland, the SNB kept its ultra-loose monetary policy unchanged during its 16th June meeting. Deposit and policy rates remain at a record low of -0.75%. The SNB raised its short-term inflation outlook slightly but, similarly to the FOMC, sees the trend evening out in the longer term. As the European recovery gathers pace, with strong increases in business activity in June, the jury remains out on the Swiss outlook.

  • 29th June: US CB Consumer Confidence is expected to remain strong in June
  • 1st July: German and French manufacturing PMI figures are expected to show continued strong performance, as the eurozone recovery kicks into gear
  • 2nd July: Watchers will be looking out for any evidence of slowing in the US labour market, when Non-Farm Payroll figures are released in the June jobs report  

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