The US faces a tough year as it continues to struggle against the pandemic. Photo / Getty Images
Opinion:
Inflationary pressures are building up rapidly across the US economy, forcing the Federal Reserve to shift gears and signal a much earlier rise in interest rates than previously suggested.
David Clarida, the Fed's vice-chairman and policy guru, has announced that rate rises will kick off once US inflation tops 2 per cent and remains there for a year. While the language was couched in reassuring terms, it amounts to regime change in monetary policy and has serious implications for overheated asset markets.
The Fed's preferred PCE measure of inflation is likely to hit 2 per cent by the spring as the US economy opens up and the base effects of surging commodity prices feed through. This points to rate rises by May 2022. "The messaging shift is seemingly happening much faster than we anticipated," said Tom Porcelli from RBC Capital Markets.
Investors had been assuming that the Fed would let the economy "run hot" as far out as 2023-2024 to soak up hidden slack before hitting the brakes.
The hawkish timetable adds credence to comments from several regional board chiefs that the Fed will start to taper QE bond purchases and drain global dollar liquidity as soon as this year.
The step-change in Fed policy comes as the incoming Biden administration prepares a $2 trillion stimulus package, likely to turbocharge a V-shaped economic rebound as middle-class Americans let rip with pent-up savings accumulated during the pandemic.
"The Fed is trying to row back," said Marc Ostwald from ADM. "Before, they feared that fiscal stimulus would be too small if there was a divided Congress. Now it looks like everything is going gangbusters and they are more worried that the economy is going to be running hot a lot quicker, and a lot hotter, than they expected."
"Asset market pricing is all based on the assumption that central banks won't raise rates. If they now pull forward their timelines, it is going to upset the apple cart. The 'skew-positioning' is extreme, especially in credit where everybody is super-leveraged. It's frightening," he said.
Monetarists warn that a massive expansion of the money supply over the last nine months almost guarantees an inflationary spiral once life returns to normal, and the 'velocity of circulation' recovers. The broad M2 measure has risen by 24pc over the last year. Nothing like this has been seen before in modern times.
Professor Tim Congdon from the Institute for International Monetary Research said it is extremely unlikely that the excess money will be sucked out of the system again. He warned US inflation could explode to double-digit levels before the end of next year.
"The likelihood of US inflation exceeding 3 per cent is very, very high. In my view, it is more likely to be 5pc to 10pc when it peaks, probably before mid-2022," he said. Such an outcome would turn the global financial system upside and have dramatic ramifications for asset prices of all kinds.
Inflation expectations are already picking up sharply though they are not yet "unhinged", to use a term in central bank parlance.
The closely watched "forward rate" five years ahead has leapt by 36 basis points to 2.08pc since the election and is approaching levels last seen in late 2018, a time when the Fed was fretting about incipient inflation and withdrawing liquidity fast though bond sales (reverse QE).
The latest NFIB survey of small business shows that 22pc of firms plan to raise prices, comparable to pre-pandemic levels a year ago when service inflation was surging. The numbers reporting a lack of inventory is the highest on record and has even exceeded the worst periods of overheating during the final blow-off of the Great Society in the early 1970s.
Those in the deflation camp fear that the initial exuberant rebound could burn itself out in a couple of quarters as the delayed effects of higher unemployment hit in earnest and the deeper damage left from the pandemic becomes clearer.
But it is also clear that conditions today are very different from the deflationary phase after the Lehman crisis when banks were being forced by regulators to beef up their capital ratios and constrain lending. In a sense, QE was required merely in order to prevent a contraction of the money supply.
Mr Porcelli said those relying on that episode to argue that inflation remains benign today are "comparing apples to oranges".
"All of the pieces are in place to witness a massive demand/supply disconnect in the economy. The consequence is textbook higher inflation. The question is not whether we will get an acceleration in inflation in 2021, but to what extent this inflation surprise will shock us," he said.
- Telegraph Media Group