Question of the Day - Inflation

As we mentioned in our quarterly webcasts last week, inflation is the data point that seemingly everyone is focused on these days. Central banks are watching inflation closely as they determine when and how quickly to normalize monetary policy. Market participants are watching inflation to decipher when and how quickly central banks will normalize policy. Put simply, monetary policy matters and inflation has become the key indicator to determine how the level of accommodation will evolve.

Despite low unemployment in most advanced economies and improving growth around the world, inflation is the one metric that is not running at levels consistent with the goals of central banks. We believe the timing of monetary policy normalization will impact not just government bonds, but also risk asset sectors ranging from corporate bonds to stocks to alternative investments. Post the financial crisis, central banks have expanded their balance sheets at a rapid pace in an effort to push all asset prices up.
 

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The Fed has started to reduce the size of its balance sheet through tapering (see note here), and the ECB will likely be reducing the size of their purchase program early next year. The Fed is also likely to raise the Fed Funds Rate at its December meeting. To date, these actions have not mattered to risk assets as stocks continue to hit new highs. However, it is interesting to note that the market is calling the Fed’s bluff in terms of the pace of future interest rate increases. The chart below details the Fed’s dot plot, which illustrates where the FOMC expects the Fed Funds Rate to be in the coming years. The solid line represents investors’ expectations for where the FFR will be.

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If inflation rises above recent levels, the market may price in a pace of future rate increases that is consistent with the Fed’s expectation. This could impact risk assets negatively as tighter monetary policy is generally not positive for valuations. If inflation remains tepid, the Fed may move at a slower pace, which would keep the supportive environment for risk assets in place for a while longer. The Core Consumer Price Index, which excludes the volatile food and energy components, printed on Friday with a level of 1.7% y/y. This metric has now missed economist estimates six out of the last seven months and is short of the Fed’s 2% target. So for now, we are not seeing the inflationary pressure that would cause the market’s expectations to move, but how inflation evolves is the question of the day. 

Source: Barclays, TD Securities