Bond investors remain confused about inflation as doves rule central banks
There is a lot of confusion among investors regarding inflation. There are two schools of thought: those who think it is a problem and those who don’t.
Since Treasury Secretary Janet Yellen, former Federal Reserve Chairperson and successful economist in her own right, is part of the latter group, investors are reluctant to get too aggressive in anticipating Fed action to raise rates. But Yellen has an agenda, and as a politician she may not be as trustworthy as she once was.
In any case, on Sunday, Yellen reiterated his view that it would fall back to the 2% level by the middle of the second half of 2022. Even so, it is almost a year away.
The yield on the Treasury benchmark fell back below 1.64% in Monday’s trading after hovering at 1.67% earlier today.
The 10-year yield briefly exceeded 1.68% on Friday after last Thursday’s was slightly below expectations at 290,000, indicating that the economic rebound continues to be robust.
Transient inflation vs demand-driven price escalation
Some investment strategists agree with Yellen and Fed Chairman Jerome Powell that inflation, while proving to be more persistent than expected, is a transient phenomenon resulting from supply chain disruptions. They claim it is not demand driven, although there is considerable evidence to support this theory, including anecdotes from the Fed, where contacts in different districts signal very high demand pushing up prices.
For now, the doves seem to have the upper hand over politics, as Yellen and Powell may continue to push back the timeline for falling inflation. Yellen wants to get some semblance of the administration’s ambitious spending plan through Congress and Powell wants as many jobs as possible and another four-year term as president.
The announcement last week by Jens Weidmann, the head of the central bank of Germany, of his resignation after 10 years of fighting against easy monetary policies in the board of governors of the European Central Bank, marked the exit of one of the most important bank hawks. While his successor is likely to still be relatively hawkish, the popular assumption is that he will be less so.
But that doesn’t mean the hawks are wrong. Investors are right to be confused and cautious. For years, central bankers struggled with the inherited ideology that expansion of central bank balance sheets in the aftermath of the 2008 financial crisis would lead to inflation. It never was, and now they think such notions are obsolete.
But the earth still revolves around the sun, the laws of gravity always bring things down, and the story is not over. Economic fads come and go and post-Keynesian thinking is now on the bottom line while Milton Friedman – who strangely believed that a flood of money would inevitably lead to inflation – is for the time being out of date.
Monetarist economist Brian Reading, a government and media veteran, argues forcefully that stagflation is within reach, as little-noticed inflation by pushing costs means higher prices will lead to higher unemployment, unlike demand-driven inflation, in which lower unemployment leads to higher prices.
His argument — in two recent articles (here and here) for OMFIF (Official Forum of Monetary and Financial Institutions), where he sits on the advisory board — is subtle, but he joins the growing crowd that debunks the widely held idea. in central banks that inflation expectations are channeling price increases.
On the contrary, he says, price shocks, however transitory, are as contagious as COVID-19, and spawn wage demands and further price increases that will not go away quickly. Central banks, which still support “unsustainably overvalued stocks” will be forced to act. A crash, he concludes, is now inevitable, but the sooner central banks pull out the bowl of punch, the better.
It sounds grim, but what if he was right?