Oh inflation, where art thou

Powell says inflation can exceed 2% target

Asian markets today are digesting the implications of Federal Reserve Chairman Powell’s Jackson Hole address overnight. The two key takeaways being that the Federal Reserve will allow inflation to overshoot its 2.0% target to get an “averaging” effect. Secondly, rates are going to be lower for longer and longer.

The first is really an admission that the last 12 years since the GFC has not produced notable wage inflation, despite a booming post-crisis employment market. Almost certainly to be a similar case once we emerge from Covid-19. The second is an admission that the recovery this time is not going to be the nirvana-like V-shape so often postulated by the gnomes of the stock market.

Predictably, the US yield curve steepened with 30-year rates rising more than the 2-year short-end. That explains why banks led the Dow Jones and S&P 500 higher overnight; banks make more money theoretically with a steeper positive yield curve.

Of course, that doesn’t mean the Federal Reserve is going to tolerate structurally higher interest rates at the long end either. The US government has a lot of bond issuance it will need to do in that part of the curve to cover its eyewatering fiscal deficits in the years ahead. Assuming it gets its act together on that front. And a good bout of inflation globally is going to be about the only way the world will be able to deflate the government debt to manageable levels, aka Fed actions post-World War 2. Sadly, this is not the 1950’s where life was so much simpler, and the real challenge is how to generate the aforementioned inflation, without it becoming 1970’s stagflation, the Dark Lord of economics.

With that in mind, although not explicitly mentioned, we will almost certainly see the Federal Reserve following the Bank of Japan into some sort of yield curve control programme in the years ahead. Short of dropping suitcases of US dollars at the doors of US citizens, the quantitative easing efforts of the Fed will have a declining marginal utility, especially as they had got nowhere near reducing their post-GFC balance sheet before Covid-19 hit.

Their inability to wean the world’s economy of the opioid of zero per cent central bank largesse means, to my mind, that the spike in US rates will be transitionary, and a return to the mean (lower) beckons. In the near term, though, it potentially sets up a short-term correction in the US dollar sell-off and precious metals. I expect the word “inflation,” to be twisted by the FOMO gnomes of the stock market into another bullish signal. Inflation means company earnings rise, yes? Buy Mortimer, buy.

With Mr Powell’s address out of the way, Asia looks to be easing into the end of the week. President Trump’s Republican Convention speech is in progress and could produce a few headline-driven short-term moves. Otherwise, Malaysia’s Balance of Trade is the region’s highlight today. Having posted a Covid-19 reopening bounce to MYR 20.9 bio last month, the headline figure is expected to fade to MYR 16 bio today, with petroleum product prices weighing on exports. With the US dollar slightly stronger on higher yields, pressure in the short-term could weigh on the ringgit.

US Personal Spending data for July hits the wires this evening, with the Core PCE Index expected to rise 0.50% MoM. Given the data looks back to July, and here we are almost in September, it is unlikely to encompass the full effects of Covid-19 sweeping the US sunbelt. However, a negative reading may set up stock markets for a nervous finish and nip the incipient rise in US yields in the bud, as quickly as it started.

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