To Inflation and Beyond
A quick dissemination of how the new inflation targets impact us
Inflation Above 2%
Earlier this week the US Central Bank, more commonly referred to as the Fed, announced the reassessment of a major policy. Prior to the announcement, the target inflation level was 2% in absolute terms so interest rates got lifted and asset purchases slowed down when approaching the level. Now, this target will be an average instead. That means in any given period, inflation could be allowed to run ahead of the standard 2% target before the Fed conducts any monetary policy adjustments such as increasing interest rates.
Photo by Frederick Warren on Unsplash
This new flexibility suggests inflation will generally tend towards the higher levels as central bankers embrace a low/negative interest rate environment and full employment is hotly pursued, particularly for those on the lower income spectrum. Due to the influence and key man risk the Fed possess, it is likely that central banks globally drift towards similar policy amendments. Central banks are inextricably linked but with the US being the first mover, its currency continues to get crushed.
Structural Impacts
Such departure from previous policy management may seem small in of itself but it will have quite a piercing impact on the macroeconomy. First of all, it all but confirms interest rates are not going anywhere higher in the short term as higher inflation rates will be tolerated for longer. Therefore, core short term borrowing costs should remain dirt cheap which is great for corporates and anyone with could access to credit. For those who can’t access credit in order to fuel investment and growth, they will see no benefit.
On the other end of the yield curve i.e. that which represents longer term borrowing, this could point higher as markets anticipate overshoots in inflation causing rates to be jacked up. The thing is the Fed could assume multiple timescales in determining its average inflation rate so there will be some speculation as to what that looks like. in any case, yield curves may look steeper going forward so banks and other institutions that borrow short term and lend long term should benefit from the new normal. In terms of the impact on risk assets such as stocks, it is quite multifaceted. Looking through the lenses of the corporations whose stocks actually make up the market, cheap access to short term credit for longer will be an obvious win. However, if risk free rates (seen as a useful benchmark when pricing company debt) increase in expectation of higher interest rates more longer term then this could drive up the yield on new bond issuance in certain buckets, representing a higher interest bill and thus cost of debt.
Similarly, when it comes to valuing stocks, some methods require the discounting of future cashflow in order to determine present value. If longer term referenced rates are higher, the discounting process will be larger and theoretically in this particular exercise, stocks would be valued lower compared to today. This doesn’t mean stocks prices will drop as things can stay overvalued perpetually. Against a higher inflation backdrop, one would assume prices of goods and services would reflect this as the underpinning factors. Companies charging higher prices should be good for revenue assuming their customers can still spend comfortably. If wage inflation doesn’t rise in line then this may pose an issue - this is a sticky situation at present. there are so many inflation linked consumer products out there including student loan interest repayments, rail fares and mobile phone contracts so allowing higher inflation rates will affect our pockets through higher costs.
Photo by Roman Fox on Unsplash
On the investment side, tons of inflation linked bonds and other securities exist so institutions including your pension fund stands to make/lose a lot of money. Overall, time will ultimately tell and as more central banks across the world adopt similar practices we it will become more clear what reality will hold. The onslaught of cheap cash and consequential yield hunting is here to stay and we will probably see more policy measures that massage the investment process especially if it supports job creation. If you want to tap into more macro based analysis, commentary and a personal voice please follow David.
The Bottom Line
In short, adopting a more accommodating approach to managing inflation could see it tend higher over time. Higher inflation impacts numerous consumer and investment products as well as the interest rate outlook which underpins borrowing costs. A useful exercise would be to have a look at which inflation linked products you are exposed to so you can be aware of any noticeable increases in the future.
Until next time,
Peace ✌🏾
Josh