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This article is part of our Investment Symposium series, in which we reflect on the big issues. For this series, we are building on the annual Investment Symposium, a key event where investment professionals from BNP Paribas Asset Management focus on the themes that shape the future. It is also a place where high-level external speakers shed new light on the challenges of our time, test our convictions and diversify our reflections.

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The outlook for US inflation and the appropriateness of US monetary policy was at the heart of our Investment Symposium. Professor Olivier Blanchard explained why, in his opinion, a secular rise in inflation is underway, which will force policymakers at the US Federal Reserve to implement a more severe and rapid tightening of monetary policy.

In this article, we take a look at the events so far before providing an outlook based on our bond team’s forecast.

Fall 2021, US inflation takes off …

Inflation in the United States, as measured by the Consumer Price Index (CPI), made headlines at 6.2% in October, its highest level in three decades. The Fed’s favorite measure, the Core Personal Consumption Expenditure Index, rose 4.1% from a year earlier.

Data for November showed that the CPI rose 6.8% from 12 months ago – the fastest annual pace since 1982 and a significant recovery from October (see Chart 1).

Between October and November, prices jumped 0.8%, down slightly from the previous monthly increase of 0.9%.

According to the Bureau of Labor Statistics (BLS), “large increases in most component indexes” fueled the rise with gasoline, shelter, food, and used and new vehicles “among the biggest contributors “. Excluding volatile prices for items such as food and energy, the core CPI rose 0.5% from October. This pushed the annual pace to 4.9% from 4.6% in October.

Factors pushing US inflation up

Faced with strong demand, US businesses had clearly raised the prices of consumer goods and services steadily, while supply bottlenecks and a shortage of skilled workers pushed costs up.

Our view is that US inflation is primarily driven by the response to Covid-19. During the pandemic, there has been a huge rebalancing in demand from face-to-face consumer services towards goods, with spending on durable goods such as cars, appliances and computers increasing particularly sharply. More than three-quarters of Americans have made at least one improvement to their home in the first three months of the pandemic, according to Statista.

This demand has encountered supply chain problems in various parts of the world, leading to widespread shortages and significant upward pressure on the prices of goods and materials, from computer chips to rubber and from coal to drugs. Global freight rates have increased due to surging demand, factors such as Covid outbreaks in ports and the blockade of the Suez Canal.

Labor markets remain tight

At the same time, Covid has caused major disruption in labor markets – and Americans have been reluctant to return to work.

Along with concerns about the risk of contracting the virus, the extremely generous unemployment benefits that helped prop up the economy during the crisis have kept workers at home, as have excess household savings built up during the pandemic.

US decision-makers under pressure

Rising inflation in the last quarter of 2021 created a deplorable economic situation, characterized by weaker growth and higher prices.

The damage caused by inflation to household purchasing power was underlined by Jay Powell during his speech, for the first time after his re-appointment as President of the Federal Reserve to the US Senate on 11/30 / 2021. New Fed Vice Chairman Lael Brainard echoed that message.

So the Fed changes course

In the face of continued upward pressure on prices over the last few months of 2021, the Fed has clearly become uncomfortable with its current extremely accommodative policy.

At the FOMC meeting in early November, it took the first step towards tightening its policy by cutting its asset purchases by $ 15 billion per month. On 11/30/2021, President Powell said he believed the reduction in the pace of monthly bond purchases could move faster than the schedule announced in early November.

So far, Fed officials have maintained that inflation will be “transient,” a phenomenon defined by Powell as leaving no lasting mark on the economy. The word appeared in the post-meeting statement in early November, but at the end of the month the president said it was likely no longer useful:

“The word transient has different meanings for different people. For many, it carries a feeling of short-lived. We tend to use it to mean that it won’t leave a permanent mark in the form of higher inflation.. I think it’s probably a good time to take that word out and try to make it clearer what we mean.

A hawkish pivot, to the dropper of investors?

The Fed’s Federal Open Market Committee last met to review monetary policy on December 15 and released what financial markets interpreted at the time to be a package of benign measures (see our article here for a full account of their decisions).

However, the January 5 release of the minutes of that meeting changed the market perception of the Fed’s position.

In our bond team’s view, the minutes underscore the fact that most of the FOMC committee thinks it is appropriate to start breaking off the balance sheet soon after interest rate hikes start.

The market was surprised to learn that “almost all” FOMC participants believed the Fed should shrink the size of its balance sheet (i.e. start selling bond holdings acquired through quantitative easing) once there has been an increase in its prime policy rate.

Overall, we see these minutes as the signal for a hawkish turn. The fact that Powell did not bring up the idea of ​​a simultaneous balance sheet roll-off and rate hike during the question-and-answer session after the FOMC in December suggests that the Fed is looking to “fuel drip “a hawkish fulcrum for investors.

The markets reacted by further broadening their expectations of upcoming US rate hikes (see graph 2).

Transitional transition or change of regime?

One of the biggest questions for investors in 2022 is whether the low inflation regime in place since the Great Financial Crisis of 2008/09 is now over. During this period, a number of factors combined to keep US inflation unusually low. These factors included:

• Debt – High debt has discouraged private sector consumption
• Demography – Aging populations consume less and save more
• Globalization – Offshoring has allowed cheaper supply chains to replace expensive onshore labor and production
• Technology – Automation has substituted capital for labor; the rise of corporate superstars has removed the bargaining power of workers.

Today, there are signs of regime change resulting in part from the pandemic. This has accelerated the trends already underway. Among the catalysts are:

• Demography – Raising the age of the working population is now reducing labor supply (the baby boom generation is retiring), while the demand for services from older cohorts is increasing
• Protectionism – The rise of populism has resulted in a rise in protectionism; the focus of supply chains shifts from efficiency to resilience and reliability, which encourages offshoring
• Politics – There is growing political pressure to tackle income and wealth inequalities, possibly through redistributive tax policies and higher wages
• Debt inflation tax – The high level of public debt encourages higher inflation and financial repression
• Tax domination – Central banks may have to deal with budget deficits to meet their full employment targets
• Green transition – A rush to produce renewable energy with limited storage capacity and a lack of investment in traditional energies could lead to higher and unstable energy prices.

Watch this space as we chart the developments in 2022.

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All opinions expressed herein are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may have different opinions and make different investment decisions for different clients. The opinions expressed in this podcast do not constitute investment advice in any way.

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