Jason R. Vaillancourt, CFA

Inflation likely to pressure the Fed

Jason R. Vaillancourt, CFA, Co-Head of Global Asset Allocation, 7/24/2014

The most pressing issue for global markets for the remainder of the third quarter will be the mounting challenge for the U.S. Federal Reserve to keep reinforcing its “optimal control” framework in the face of higher inflation data.

Striking the right balance The Fed has a dual mandate under the law: to pursue policies that promote full employment and price stability. But many years into the recovery, we are, in the Fed’s view, still far from full employment. The idea behind optimal control is that the Fed will be more tolerant of adverse moves in one objective if it is still far from achieving the second objective. In the current case, this means the Fed is willing to tolerate a little bit of inflation because it believes there is still quite a bit of slack in the labor market. In particular, the Fed has noted that real earnings, or wages adjusted for inflation, have started to stagnate recently.

Policy communications face higher stakes The constant reinforcement of the “easier for longer” message by the Fed has contributed to keeping both short rates and overall market volatility very low. As we move through the balance of the year, continuing to reinforce that message runs the risk that at some point, markets may come to view the Fed as being behind the curve and needing to tighten policy faster than what is currently discounted in market prices. This scenario would cause short rates and volatility across asset markets to rise quickly.

Recent signs of inflation Fundamental inflation measures look set to rise steadily over the next several months, in our view. Indeed, inflation “surprises” have already risen dramatically, in that inflation data have come in above economists’ expectations.

Inflation may be an emerging trend

Rising inflation data would put upward pressure on short-term rates. As we have said in the past, rising short rates in and of themselves do not necessarily present a problem for the real economy. Indeed, there is a link between real rates of interest and real economic growth. With growth clearly improving since last winter, rates should move higher.

Market volatility could increase For risk assets, such as stocks and high-yield bonds, the potential for volatility comes as the Fed struggles to handle the communications about its policy steps. It is unwinding the extraordinary policies that have been in place for several years. This long period of cheap money and low volatility has created favorable conditions for many market participants to reach for yield in a leveraged fashion.

Depending on how quickly the Fed makes further policy moves, both low-cost funding and low volatility could vanish quickly.

Read Putnam Capital Markets Outlook on Slideshare or download the PDF from putnam.com.