As we head into this week's Federal Open Market Committee meeting, when the Fed will deliberate over its interest rate policy and quantitative easing intentions, the market is still licking its wounds from the June FOMC statement.
In June, the Fed took a slightly hawkish shift as it moved its median dot plot to show two rate hikes in 2023. The market had gotten used to the Fed not even close to "thinking about thinking about tapering" where in June, it seemed the members were closer to discussing that option. The data over the past few months has turned very inflationary, previously mooted as "transitory."
Even the Fed has made comments recently how inflation may last higher for a bit longer. Given the amount of global central bank stimulus in such a short period of time to cause such a surge in demand for raw materials and goods and services, it should really come as no surprise. The latest consumer price index reading of 5.4% and core CPI at 4.5%, was the highest for the latter since 199. The big question on everyone's minds is, Will the Fed be forced to taper sooner rather than later?
But the more important question is, Can it afford to do so?
Quite a few of the transitory camp analysts pointed out that most of the increase in CPI came from temporary supply side disruption, like used car prices. There is some supply side disruption that will last for longer, causing prices to stay elevated, but one of the components of the CPI that had been lagging, namely rent inflation, is now slowly picking up. According to the Zillow Observed Rent Index, rent was up 1.8% month on month in June, showing a year-over-year increase of 7.1%, the largest annual rise going back to 2015. They are up 5.1% since March, the fastest quarterly growth in Zillow's data.
If used car prices or other components do not come down fast enough, then this laggard portion of the index might keep average CPI prices higher, which will start to be the Fed's nemesis. Given that we are almost out of the pandemic-struck lockdowns with all parts of the economy bouncing from the lows of last year, one wonders why the Fed needs to still keep buying $120 billion a month of Treasury purchases. As of last Friday, its balance sheet reached an all-time high of $8.24 trillion. Will we hear of the Fed trimming back some of the MBS or Treasury purchases?
Since the stimulus-driven expansion of last year, recently Global PMIs have been showing signs of slowing down. They are still at robust levels, but the rate of change is down, for example growth seems to be plateauing. To keep the economy rolling on, will the central banks consider printing more money when they did not even manage to reduce their debt at all post the rebound? When the next crisis hits, will the Fed need to print another $5 trillion or $10 trillion? Only time will tell, but the Fed is in a bit of catch-22.
The Fed hopes that all its efforts will lead to sustainable gross domestic product growth, but if inflation starts to run away faster than growth, then the Fed's hands will be tied. Rates globally are close to zero, or negative, they cannot go any lower. If CPI and other inflation metrics keep staying elevated for longer, that is a scenario the market is not priced for, stagflation. The Fed's only choice then would be to raise rates and/or tighten monetary accommodation. We know what that means because this entire market is built on a very delicate house of liquidity.
One of the factors that can save the U.S..market is the U.S. fiscal stimulus bill, if it is passed, it will take the pressure off of the Fed to keep increasing their balance sheet. Whether democrats and republicans reach a mutual agreement is yet to be determined. But one thing is certain, after the massive growth spurt we saw last year post lockdown, China along with developed markets are now showing signs of fatigue. Will Daddy Powell be forced to come back to rescue the market?