We’ve written a lot lately about the Federal Reserve’s attempt to restore credibility on inflation. Judging by this week’s price movement, the Fed has convinced the market that it will raise rates faster than expected, but not that it will do much for near-term inflation.
Let’s start with the most striking evidence: break-evens, which are the closest we have to a real-time market reading of the direction of inflation. Recall that equilibrium rates are calculated by subtracting the yield of an inflation-protected bond from the yield of a nominal bond over the same period. The five-year break-even rate stood at 3.42% at the start of the March Fed meeting. On Friday, the five-year break-even rate was 3.57%. In other words, the market’s view on inflation has deteriorated since the last meeting. In fact, it is now at an all-time high.
The stock market rose during the week, another sign that investors don’t believe they are seriously “fighting the Fed” by taking stock risk. This is in fact the second consecutive weekly gain. Bond yields have risen, but this is ambiguous evidence. This certainly seems to imply that investors aren’t all that worried about inflation (even if the yield curve continues to flatten). On a deeper level, the fact that the 10-year Treasury has achieved the highest yield since before the pandemic could mean that investors think the Fed will raise rates aggressively, or it could just be a sign that they expect a lot of inflation and therefore demand a higher return to compensate.
This is a fairly familiar pattern with the markets. The Fed’s credibility problem likely dates back to the Trump era, when the Fed initially hiked rates aggressively and without any evidence of inflation. After months of criticism from President Trump (who was widely hated by the establishment media), the Fed admitted its mistake and turned to an average inflation targeting regime that probably would have been appropriate. during the Trump presidency. In other words, the Fed was more or less admitting that it had followed the wrong policy for years.
The Fed then did it again by mistakenly identifying inflation as transitory, mistakenly predicting that narrow inflation would stay narrow, and refusing to rise from the zero-rate floor until it was, as they say. on Wall Street, “behind the curve”. Now the Fed is engaged in a pitched battle with the markets. Every time the Fed tries to communicate a new level of inflation-fighting commitment, the market tests it by easing financial conditions in the form of higher stock prices. So Fed officials need to step up the rhetoric and likely take real policy action by doing things like raising rates much faster than the market had anticipated.
But don’t think it’s just financial markets. As the University of Michigan consumer sentiment survey showed on Friday, inflation is genuinely depressing high street confidence in the economy and in policy makers. Nearly a third of households expect their financial situation to deteriorate over the next year due to rising prices, with the largest share of record highs dating back to the 1940s. Only 16% of people say they believe that we have the right policies to deal with the problems, a sure sign of a loss of faith in the Fed and the Biden administration. This will make the fight against inflation more difficult because a large part of inflation depends on psychology and expectations.
Next week we will have the reading of this month’s employment figures. The market is expecting a descent to a still extremely high level of 450,000 from the astronomical 678,000 in February. Given the strength of the jobless claims data, we wouldn’t be surprised to see a higher number. There has also been strong evidence of job growth in regional Fed surveys. The strength of the labor market could draw more workers on the sidelines, which could prevent wages from exploding too high. However, any figure above the consensus could heighten concerns about a spiral of wage and price inflation.
As we said earlier, everyone has a job, but no one is happy to work more while getting poorer.