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Inflation is up – rates to follow?

The Fed plays a long game with inflation

Inflation has jumped higher than expected — commanding headlines, worrying investors and roiling markets. What’s behind the Fed’s new approach?

Inflation is not always a bad thing

Sustained high inflation can raise the cost of living and stunt business growth. But low and predictable levels of inflation, like what we’ve experienced over the past 20 years, are generally viewed as having a positive influence on supply and demand, employment and economic growth.

One reason the markets may be reacting strongly to higher inflation numbers today is the historically low inflation environment we’ve enjoyed since the turn of the century. For most of that time — and through two broad economic cycles — inflation has remained low and range-bound. Over the period as a whole, it has trended downward.

“A number of what I would call structural factors have conspired to bring inflation down across the developed market world,” says Edward Al-Hussainy, Columbia Threadneedle Investments’ Senior Interest Rate and Currency Analyst. “These include demographic changes, advancing technology, globalization, the evolution of services and, importantly, the actions of central banks. Any rise in inflation in this or the coming years would come off these already low levels and have to push against these growing trends.”

An evolving relationship between rates and inflation

The actions of central banks, unlike the other factors, are intentional and controllable, and may be losing some of their effectiveness.

“Historically, central banks have responded to inflation levels above or below their policy objective by setting interest rates to loosen or tighten credit conditions and to stimulate demand,” says Adrian Hilton, Columbia Threadneedle Investments’ Head of Global Rates and Emerging Market Debt. “The understanding of the link between underlying rates and inflation, I think, is about as poor as it’s been for a long time — probably worse than any point since inflation targeting took off in the late 1990s.”

Since the 2008 financial crisis, central banks have struggled to meet their inflation targets to generate enough demand. “That’s a problem,” continues Hilton, “because if you can’t create inflation with labor markets as strong as they’ve been, you may never get to the point where you can raise interest rates. If you can’t raise rates off these rock bottom levels, then you’ve got a problem when the next downturn arrives — you don’t have room left to cut rates to stimulate the demand you need to energize a recovery.”

The U.S. Federal Reserve has responded to this problem with a new approach to inflation policy called flexible average inflation targeting (FAIT). Using this method, they hope to maintain an average target level over time. This allows for higher levels of inflation over shorter periods to run the economy “hot.” This spurs growth and takes the pressure off maintaining an overly tight monetary policy.

FAIT has some segments of the market worried, because it implies a potentially more permanently inflationary path. And if the Fed is inclined to leave its foot on the accelerator longer to speed up the recovery, it probably does mean keeping rates low for longer in the near term and a more inflationary profile further out.

“The question for investors is, can the Fed hold its nerve?” adds Hilton. “The market has recently been testing the Fed’s commitment to forward guidance by starting to price in a slightly more aggressive pace of interest rate hikes than they had at the start of the year. And as we run into some of those base effects this year as the consumption recovery gathers steam and we start to see inflation moving higher, there’s going to be more and more pressure on the Fed to cool things off.”

“We know that because of base effects, supply bottlenecks and a rebound in energy prices, there’s going to be some price pressure coming to bear,” Hilton believes. “How big that is also depends on how potent the U.S. fiscal stimulus is. The extent to which stimulus can juice demand will depend somewhat on whether consumers hold onto the money rather than spend it.”

For businesses, the outlook is more muddled. “Input costs for businesses are rising, probably at the fastest pace that we’ve seen in a decade or so,” says Al-Hussainy. “The questions are, do businesses have the capacity to pass these prices onto consumers, and can they do that on a sustained basis? And to what extent does this eat into profit margins? Those answers are still unclear.”


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Inflation is up – rates to follow?

With the U.S. Federal Reserve Chairman Jerome Powell set to announce inflation data today, many are on the edge of their seats anticipating what may be an interest rate hike coming soon. While vested interests prefer to paint a rosy picture for perpetuating a crazy market, Christiaan Hetzer at Forbes and many others reveal that the real estate bubble and inflation are just an American trend, but a global problem. But, the question on everyone’s mind today is, “Will interest rates go up?” As much as every potential homeowner would like to dream, the answer seems obvious.

Jerome Powell Boston real estate interest rates

Boston real estate interest rates

Federal Reserve Chairman Jerome Powell – Public Domain

Worldwide, housing prices are on fire and going higher at rates not seen in the last 15 years. The author points to worldwide government stimulus packages and fiscal policies padding personal incomes. He also cites a recent study showing that prices in 56 countries and territories increased 7.3% until March 2021. The same survey showed that United States prices increased by 13.2% during the quarter, which is the highest price growth since December 2005. 

Some analysts expect inflation to reach 4.9% year-over-year, but these same experts believe the Fed will take other measures before elevating interest rates. But 10-year Treasury yields are down of late, and key executives like Bleakley Advisory Group chief investment officer Peter Boockvar are fearful that 1970s-style long-term inflation will result because of stagnated higher prices brought about via housing-related inflation. He spoke recently with CNBC on the subject:  

“We are at a point where meager interest rates are no longer stimulative to the housing market. On the purchase side, we know the dearth of inventories and sticker-shock price increases are slowing the pace of transactions.”

A key concern of market analysts

A key concern of market analysts is the effect longer-term inflation will have on investor portfolios. Goldman Sachs Chief U.S. Equity Strategist David Kostin is here discussing how the U.S. equity market real return during high inflation backdrops is historically annualized 9% vs. 15% during periods of low inflation. Another hidden danger is the chasm created by varied coronavirus pandemic recoveries. Some countries (markets) see a blistering recovery on account of vaccine rollouts, while others lag far behind. This recovery, so far, is on pace to beat the economic windfall at the end of World War 2. 

So, the significant wisdom suggests the Fed will be forced to increase interest rates now. I agree with this and expect the announcement later today along these lines. As reasoning, pay attention to The Wharton School’s Itay Goldstein on the subject here. I’ll leave you with something from investing legend Jeremy Grantham. The co-founder of one of the world’s most significant investment funds said recently there would be a “day of reckoning” for this global housing bubble. For the record, Grantham is one of the few big-time investors who predicted the crash in 2008-2009. 

Finally, at the end of the day, the immense majority of “experts” say inflation is short-term and that the housing bubble can go on and on and have vested interests in selling houses. Sorry, it has to be said. Ask a real estate agent about a collapsing market. What will you hear? Well, physics is against almost all those people. The Federal Reserve has to elevate interest rates just a little.

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Updated: Boston Real Estate and Condos for sale 2021

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