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The Potential for Inflation Rebound and its Impact on Financial Markets

3 Mins read

Just as investors begin to accept the notion that there won’t be a Federal Reserve interest rate cut in the near future, a new scenario is gaining traction that could disrupt financial markets this year. This scenario involves the risk of inflation rebounding, which would put policymakers in a position where they would need to react swiftly.

Economist Tiffany Wilding from California-based bond fund Pimco recently released a note to clients highlighting that recent data suggest progress on inflation in 2024 may be slower and more complicated than previously anticipated.

For the past few months, investors and policymakers have been primarily focused on the likelihood of three or more quarter-percentage point cuts in the Fed’s benchmark rate in 2024, as well as the deceleration of inflation. However, officials have pushed back against the notion that they would begin easing policies as early as March. Instead, policymakers are looking for a sustained decline in inflation towards the 2% mark before taking any action, which may require additional time.

What has yet to be fully considered by financial markets is the possibility that the central bank might need to raise interest rates again. The Fed has already raised borrowing costs by over five full percentage points since March 2022. Despite this, Fed-fund futures are still primarily priced for at least five quarter-point rate cuts by December. When policymakers discuss adjusting monetary policy, it’s within the context of lowering rates, not raising them.

Nevertheless, there is growing recognition that the Fed’s efforts to tighten monetary policy thus far have not been sufficient to restrain the U.S. economy. Minneapolis Fed President Neel Kashkari recently noted in an online essay that the central bank’s rate and balance-sheet policies may not be as tight as previously assumed and that the “neutral” level of rates (neither accommodative nor restrictive) may have risen. However, Kashkari did not explicitly suggest the need for another rate hike, but rather emphasized the importance of maintaining rates at their current levels of between 5.25% and 5.5%.

Conclusion

The possibility of inflation rebounding in the coming years presents a considerable risk to financial markets. While investors and policymakers have been focused on the anticipation of rate cuts, there is a growing realization that the central bank may need to raise interest rates instead. It remains crucial for policymakers to evaluate the pace and timing of monetary policy adjustments to effectively navigate this complex landscape.

The Economy Remains Robust, but Risks Loom

Since last Friday’s release of the January nonfarm payrolls report, the data has been consistently positive, with a higher-than-anticipated 353,000 job gain for January. This only strengthens the belief that the economy is still standing strong. However, there are concerns regarding inflation.

Annual core inflation, based on the Federal Reserve’s preferred indicator, is nearing 2%. Yet, officials are not yet confident as this level has not been sustained for a sufficient period of time.

Pimco’s Perspective

At Pimco, analyst Wilding remains cautiously optimistic, hoping for a soft landing for the U.S. economy. However, she acknowledges that the risk of persistent inflation is particularly prominent in the U.S., where she believes growth has the potential to be more resilient than in other developed economies.

Wilding stated, “We are closely monitoring risks in both directions: the possibility of growth stagnation or a resurgence of inflation. We also trust that the Federal Reserve would swiftly and resolutely address any signs of rising inflation. Central bankers are determined to avoid repeating the price spikes of the recent past.”

Financial Markets React

Following Federal Reserve Gov. Adriana Kugler’s comment that it is crucial for inflation to return to 2%, financial markets remained relatively calm on Wednesday. All three major U.S. stock indexes (DJIA, SPX, COMP) were higher in late-morning trading in New York, while Treasury yields were mostly unchanged ahead of a $42 billion auction of 10-year notes. Additionally, the prospect of a potential ceasefire between Israel and Hamas in Gaza limited oil-price gains.

Expert Consensus

Wilding’s perspective aligns with other experts in the field. In January, James Solloway, chief market strategist and senior portfolio manager at Pennsylvania-based SEI, warned that inflation is still a concern and doubts that it can be brought back down to 2% “without some amount of pain.” Similarly, Brent Schutte, chief investment officer at Northwestern Mutual Wealth Management Co., described wages as “the one remaining ember that could reignite inflation.”

In conclusion, the U.S. economy continues to display strength, but the threat of inflation looms. Analysts are keeping a close eye on potential risks and anticipate rapid intervention from the Federal Reserve in the event of a resurgence in inflation.

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