High inflation is not transitory, says US Fed - Will risk assets still only go up?
Many Central Bankers have been continuously saying that inflation is transitory during the last several months. COVID has led to demand-supply imbalances and that has pushed prices of various commodities higher. I am guessing that the assumption was that as the supply of various goods normalizes, the demand-supply imbalances will reduce causing inflation to fall to more palatable levels. However, the US FED just did a 180 on their statement.
What have been some of the major contributors? Surely, energy prices have been a major culprit. Once economies started opening up, demand opened up pretty smoothly. However, what about supply. Well, factories do not just increase capacity overnight. The transport/shipping/warehousing capacity does not simply double because of pent-up demand that is probably not permanent. There are huge bottlenecks at ports, stuff had to be cleared, pending orders completed and supply just could not keep up with demand. Labor shortage is another issue. Economists now think that this may continue well into 2022. Welcome Omicron! 🤦♂️
This leaves investors as well as the US Fed (or any central bank) in a difficult spot in my opinion. If the Fed decided to reduce the number of bonds they buy, they influence the interest rate curve overall. Also, it reduces the amount of liquidity available in the overall market. That impacts risk assets and hence investors. The impact on an investment portfolio has far less of a negative impact on the economy as opposed to say interest rate hikes, which is of course the second thing the Fed can do.
Consumers in developed countries are used to a sub 2% inflation rate since 2008. Their household budgets are set accordingly. Also, developed economies are credit-driven. Raising interest rates manifold can be disastrous for the US, as EMIs will shoot up for consumers that may already be seeing their budgets take a hit due to inflation.
Can the US Fed do much though? If they tighten liquidity, then risk assets will be impacted negatively in the short term. That is because their pace of liquidity tightening will be too slow. Policymakers are themselves asset-rich. However, this will not have a meaningfully negative impact on the real economy in my opinion. The cost of capital for companies will go up, and that again means higher inflation. The Fed will not tighten so much that credit markets freeze.
If the US Fed does decide to raise rates by say 0.25% to 0.5%, and this is a big IF, then also it does not tame down inflation that much. It will eat into disposable incomes, demand may be impacted slightly, but this happens over a period of say 6 months to 1 year. Interest rates take their own sweet time to percolate through the economy and have an impact.
In my opinion, inflation is here to stay around till supply bottlenecks get cleared. Any central bank action is slow and the immediate reaction is only seen in financial markets, for e.g. Yesterday -
There is little that the Fed can do at this stage. Be careful about your portfolios though as Equities only go up may not hold true many times during the next year.
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