The Fed is losing control of the inflation story.
Traders believe that even if the Fed raises its federal funds rate target by 2.5 percentage points this year to 3 percent, it will not be enough to reduce inflation from around 8.5 percent to 2 percent over the next decade.
After policymakers’ hawkish rhetoric became more aggressive last week, the Federal Reserve is poised to raise interest rates at the fastest rate in 40 years. The issue is that bond traders continue to raise their longer-term inflation expectations, which is a very concerning development for the central bank, the economy, and financial markets.
This week, 2-year Treasury note yields reached their highest level since 2018 after Fed Chair Jerome Powell endorsed the idea of a half-point increase when policymakers meet in two weeks, saying that many officials see ‘one or more’ such moves as appropriate. Nonetheless, long-term inflation expectations continued to rise.
The market-implied inflation rate for the next five to ten years has risen to nearly 2.6 percent, the highest since 2014, and 10-year breakeven rates have risen to the highest since at least 1998, surpassing 3 percent. Hoisington Investment Management Co.’s long-term bond bulls expressed concern in their first-quarter letter to investors, saying that while an economic downturn would favour buying long-term Treasuries, ‘investors should be wary’ of the Fed failing to adequately tamp down inflation.
All of this suggests one of two things: either the world’s most important central bank has lost control of inflation, or it will not even attempt to bring it back down to their 2 percent target. If the Fed wants to return to 2% inflation.
Traders agree, with breakeven rates indicating that they believe policymakers will avoid jeopardising the economy by tightening monetary policy less, not more.
With the benefit of hindsight, it appears that the Fed made a mistake by continuing to buy bonds to support the economy during the pandemic for as long as it did, despite signs of overheating in the labour market and rising inflation.
Recent history suggests that traders should not rule out further policy blunders in the future.
Indications that businesses are easily passing on rising costs may slow the rate at which inflation decelerates. Kimberly-Clark Corp. shares rose the most in 22 years Friday after the company reported first-quarter sales and profit that exceeded expectations, with the manufacturer of diapers and toilet paper successfully passing on higher costs to consumers. Travel companies’ stocks, such as United Airlines Holdings Inc., have risen as vacations and business trips return to levels comparable to or higher than before the pandemic in 2019, allowing them to raise prices.
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