Will the surge in consumer prices this year be a temporary blip or the start of a much more prolonged period of higher inflation?
That is the debate raging on Wall Street — and among Washington policymakers — as the post-pandemic economic rebound looks set to accelerate this year.
Investors have grown more attuned to the risk of rising inflation since the start of 2021, when politicians cleared the path for another massive dose of fiscal stimulus.
The eventual $1.9tn plan that the Biden administration was able to pass was implemented alongside an advancing Covid-19 vaccination campaign — prompting economists to ratchet up their growth forecasts for the world’s largest economy.
Assurances from the Federal Reserve that it would keep its monetary policy ultra-accommodative until it achieved a more inclusive recovery have also helped to lift inflation expectations. Key forecasts derived from US inflation-protected government securities recently rose above 2 per cent for the first time since 2018.
But with the likelihood of a rapid economic revival increasing, the spectre of long-dormant inflation has fixed-income fund managers on edge and taking precautions to safeguard their portfolios.
“Even if it is not our base-case scenario, I do think being mindful of the potential for inflation to exceed expectations is wise,” says Brett Wander, chief investment officer of fixed income at Charles Schwab.
“You don’t buy car insurance because you expect to get into a car accident. You buy it in case you do.”
Demand for inflation-protected securities has intensified since the start of the year, with more than $12bn flowing into exchange traded funds that invest in Treasury inflation-protected securities, or Tips, by the third week of April, according to data from EPFR Global.
Market participants expect these flows to swell further this year. Some also anticipate appetite for high-yield corporate bonds to pick up against the backdrop of robust growth and ebbing default risks.
The inflows were accompanied by a sharp sell-off in longer-dated US government debt, which resulted in the biggest quarterly slump since 1980.
Inflation is a particular concern for these bondholders, as the coupon payments from longer-term bonds are fixed over an extended time horizon and become less valuable as the overall cost of goods and services rises.
Meanwhile, leveraged loans, which pay a floating rate of interest that fluctuates with short-term rates, have also gained favour. Investors poured more than $4bn into ETFs that invest in US leveraged loans between January and mid-April.
“I don’t really remember a point in my 30-year career where inflation felt and looked [so] real,” says Steve Sachs, head of capital markets at Goldman Sachs Asset Management.
“What strikes me as different this time is that . . . investors of all stripes are looking to position and more importantly protect themselves from inflation in the long haul.”
However, Fed officials have repeatedly said that the expected rise in inflation this year will be “transitory”, easing once supply chain constraints linked to the coronavirus recovery recede.
They have also noted that the structural forces that have helped to keep inflation below their longstanding 2 per cent target — including technological development and globalisation — are still potent.
“Runaway” inflation is unlikely, agrees Mike Stritch, chief investment officer at BMO Wealth Management, without “sustained wage pressure”. In a labour market that is not yet fully recovered, such forces are largely absent.
Yet despite these assurances, the risk that the Fed may have to recalibrate its monetary policy sooner than expected is not insignificant, warns James Knightley, chief international economist at ING— especially given its new tolerance of higher inflation.
“If you’ve let things run too hot for too long, that leads to over-tightening,” he says. “This new framework could open the door to more prolonged periods of loose monetary policy that need to be corrected more quickly and aggressively than the market is pricing.”
That may mean an earlier withdrawal of the central bank’s $120bn monthly asset purchase programme— or even interest rate increases before the 2024 timeline that the Fed has so far signalled.
The likelihood of these adjustments will be more apparent later this year, adds Knightley, when there is more clarity on just how durable inflation will be.
“In the latter half of this year, that is when you get the reckoning.”