Will employment and inflation sway Fed’s interest rate policy?

The underlying forces fuelling the rise of inflation are not going away any time soon, a fixed income portfolio manager has warned.

Speaking as part of Capital Group’s 2021 Mid-Year Outlook, Pramod Atluri believes inflation is the #1 risk in the market and that it may persist longer than the U.S. Federal Reserve anticipates. He broke down inflation’s current hot run into two components. Firstly, that we’re still lapping weak markets in 2020 and, secondly, that there are ongoing inflationary forces at work.

While the first issue is expected to subside as we see the year out, problems around supply chains and low employment issues are likely to persist.

Atluri said: “My read from the analysis is that some of the supply chain issues may not clear up in months or quarters; it may take longer for different sectors of the economy. This may lead to inflation persisting above the Fed’s desired goal a little bit longer than it hopes, and [change] how this impacts my investments.

“Higher inflation clearly has an impact on both interest rates and the yield curve but more important to my mind is that if it leads the Fed to tighten prematurely, it could also derail risky asset markets like equities and credit.”

Some markets have already priced in inflation risk – the 10-year Treasury moved up almost 100 basis points from their lows last August – but Atluri is concerned that credit and other risky markets haven't really priced in the risk of an overly hawkish Fed.

Capital Group economist Jared Frank was slightly less conservative when looking at the short-term supply chain problems but still believed these constraints won’t be worked through until June of next year, which is still less temporary than many people expect. In the meantime, this promises to be an uncomfortable period for investors.

Frank also spoke about trends that are expected to become more entrenched, specifically the automation and digitization of the workforce. In fact, he believes companies are doubling down on this, which will prove deflationary over time.

However, there are competing forces at play, he explained. “What we’re seeing with fiscal policy, and by the administration's plan to inject more fiscal stimulus into the economy over multiple years, is that these tend to be inflationary impulses.

“So we’ve got these two large forces, disinflationary from automation and technological change, and the effort to support the economy post pandemic. As we bounce out into 2023-24, I think we're going to be roughly in line with the Fed’s mandate of 2%, maybe a little higher, which is a lot better than where we were post global financial crisis where we were constantly undershooting the Fed’s mandate.”

One area that is likely to cause the Fed headaches moving forward is employment and getting the country back to pre-pandemic levels. There are currently more than 7.5 million workers worse off than when COVID-19 first hit.

Atluri admitted he’s struggling with the idea that if inflation ends up being higher than the Fed expects (but not runaway) and employment is less, what is the central bank’s reaction going to be? Are they going to stay easy on interest rates until they get employment where they want?

He warned that this situation, where the Fed is staring inflation in the face while employment is lagging, is an uncomfortable position to be in, and the market will be looking for any signs of weakness in its proclaimed lower-for-longer rates policy.

“Interest rates, for the most part, have been quite low, taking the Fed at their word that they're going to focus on employment. But as we've seen with some of the commentary from the last Fed meeting, there are many governors who seem to be nervous with inflation running where it is today.

“Any wavering of commitment would mean that the market has to now price in the Fed not staying low for the next two years, and start pricing in higher rates earlier than expected.”