The COVID-19 Delta variant has slowed the economic recovery, but we are glad to see the rates of infection, hospitalization and death have waned. Unless there is another wave or a new unknown strain coming, the U.S. economy is expected to get back on the recovery track, even though peak growth is behind us.
Both headline and core inflation (CPI or PCE) have steadied, albeit at elevated levels, and the base case appears to be that peak inflation is also behind us. However, the dislocation, created last year from a self-imposed lockdown in China and then in the U.S. and a number of other countries, has created significant and long-lasting dislocations. Starting with a supply shock which was followed by a demand shock, the global supply chain, in commodities and finished goods, continues be in turmoil. The shutdown is like the start of the first falling domino which laid down all the domino pieces to follow. Since last summer, the restart of the global economy is equivalent to pushing all the fallen dominos back up, and that has been proven to be a much harder and longer task. This reversal process will likely cause inflation winds to blow much longer and sometimes harder.
The Federal Reserve’s new monetary framework – flexible average inflation targeting (FAIT) approach – targets inflation that averages 2% over a timeframe that is not defined. The Central Bank intends to allow the economy to run a bit hotter. The current above trend inflation can be thought of as a “catch-up” to the below trend inflation since the Global Financial Crisis through the global shutdown and rolling recovery (base effect) – a kind of reversion to the mean of 2%. The fear is that the policy action (rate hike) comes too late and the Federal Reserve will have to take more heavyhanded actions, derailing the economic recovery trajectory into a recession; not to mention the draining of liquidity causing a bear market in risk assets.
It appears certain that the Federal Reserve will begin reducing its bond purchasing program ($40 billion in mortgages and $80 billion in treasuries) before the end of this year. Unlike the last monetary tightening cycle under Chair Yellen, Chair Powell repeatedly stated that tapering and rate normalization or hiking are independent decisions. Although consumer demand has return significantly, it is the lack of supply of goods and commodities and the disruption in the labor market that are building price pressure. Monetary policy is typically an ineffective tool to control supply-driven inflation. Raising interest rates to tighten financial conditions does not speed up the delivery of raw materials and goods. On the other hand, loose monetary policy has inflated financial and real assets with very stretched valuation and has contributed to imbalances. Moreover, the pent-up demand during the COVID crisis with significant savings and low borrowing cost are extra fuel for the inflation fire.
It has been a sideway market in the third quarter, and the current debt ceiling, infrastructure spending and other fiscal policies are in a limbo. These and other uncertainties are not constructive for markets. But this soon will pass like they have in the past. Markets will likely remain volatile until these issues are cleared. Monetary policies will remain accommodative for some time, and that remains positive for risk assets.