Friday's Market Minute: Transitory Inflation Makes For A Messy Market

Markets failed to find some solace, despite the fact that Fed Chair Jerome Powell says the economy is far away from central bank’s employment and inflation goals and pledged to maintain easy monetary policies. After his testimony, bonds and stocks sank in tandem with relatively few places to hide. Concerns surround longer-duration rates like the 10-year yield, which is up 8 basis points to 1.55%, while the 3-month yield remains at a paltry 0.04%. Conventional Fed policy stimulates control of the short end of the yield curve, and the Fed is quite far away from raising the Fed Funds rate. Unconventional quantitative easing (QE) policy is when a central bank purchases longer-term securities from the open market and is designed to loosely anchor long-term rates. When the Fed eventually pivots towards monetary tightening, they will telegraph a QE taper first, and eventually a gradual rise in the Fed Funds rate. Powell made it clear the FOMC is still far from tapering the existing $120 billion per month QE policy, and the market reaction suggests the current QE policy may not be enough to absorb another multi-trillion dollar fiscal stimulus.

The market exemplifies concerns for what may simply be transitory inflation. For various reasons, the CPI only reflects an increase of inflation of 1.4%, but may not be representative of embedded inflation for primary living expenses. For example, the Case Shiller National Home Price Index (December) is up 10.3% year over year, due to a shortage of listed homes on the market. There is no doubt Covid-19 disrupted lives and disintermediated the flow of capital, produced goods, services, and consumption. As the economy recovers, adjustments in the flow of commodities, intermediate, and final goods will eventually normalize. Inflation expectations are high, but the economy still has slack in available labor and actual GDP remains below trend. Positive outcomes in vaccines, optimistic sentiment, and a steady recovery with the prospect of another fiscal injection led to a rapid rise in rates and a commensurate fall in highly-rate-sensitive growth equities. Disregarding the current equity valuation correction, the economy (and stock market) is still in the early to mid-stage of an expansionary business cycle and bull market.