The fear of inflation in the U.S. is palpable.
Last week, former Federal Reserve Bank of New York President Bill Dudley gave five reasons to worry about faster price growth in the U.S. in a Bloomberg Opinion column. Ray Dalio, the founder of Bridgewater Associates, cautioned this week that a “flood of money” was unlikely to recede. Jeffrey Gundlach, DoubleLine Capital’s chief investment officer, said in a webcast that inflation is headed to the 2.25% range in 2021 and could reach 2.4%. Others think it could go even higher. My colleague John Authers made the case that a unique confluence of Covid-19 related circumstances, from a surge in home prices to a sharp decline in household debt-service ratios, sets the stage for a potential generational boom in inflation.
Now add to that Thursday’s consumer price index data, which showed prices paid by U.S. consumers rose in November by more than forecast, regardless of including or excluding volatile food and energy costs. The headline figure rose 1.2% from a year earlier and the core measure increased 1.6%, beating estimates for 1.1% and 1.5%, respectively. To be sure, those still remain far short of the Fed’s 2% average inflation target, but the higher-than-expected readings at least justify 10-year Treasury breakeven rates hovering close to the highest levels since May 2019. A sharp 3.9% increase in lodging costs and 3.5% jump in airfares from the previous month certainly fit into the narrative of a full reopening turbocharging price growth sometime next year.
In ordinary times, the Fed might at least gently push back against these expectations. Now, with the central bank openly encouraging an overshoot of 2% for a period to make up for persistent misses, policy makers might feel the urge to ease even more to keep any nascent bond vigilantism in check.
This isn’t as paradoxical at it seems. It’s hardly a secret that the Fed views low long-term interest rates as a crucial way it can boost the economy through monetary policy. The average 30-year mortgage rate remains at a record low 2.71%, which unlocks refinancing opportunities for Americans across the country and creates a “wealth effect” for homeowners as the price of their house appreciates. The average investment-grade company can borrow money that won’t have to be repaid until 2032 at a yield of less than 2%, which the Fed sees as a way to help avoid job cuts. Top-rated states and cities can borrow for 15 years at less than 1%.
Those low-rate dynamics can change in a hurry if long-term Treasuries are left to their own devices during a period of persistent inflation surprises. As I wrote earlier this week, a 1% 10-year yield probably isn’t enough on its own to frighten the Fed. But if the pace of the yield increase starts to accelerate — in theory, in lockstep with a rise in inflation — that will catch the central bank’s attention.
