Why the market is concerned about Powell’s stance on inflation

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The bond market sold Thursday as Federal Reserve Chairman Jerome Powell voiced little concern about inflation and gave no indication of impending policy changes.

In an exchange with the Wall Street Journal, the central bank leader admitted that an economy recovering from the depths of the Covid-19 pandemic could face some price pressures.

But he also dismissed them as mostly “base effects”. In other words, prices will look high over the next few months, but only compared to last year when the pandemic started and inflationary pressures fell through the bottom.

In addition to pointing out full employment, Powell said, “We want inflation to be sustained above 2% and we want to be on the right track for inflation to be sustained above 2%.”

“There’s just a lot to do before we get there,” he added.

The bond markets sold during his comments, sending higher returns as prices and yields moved in opposite directions. Shares also fell, causing Dow industrials to drop more than 600 points.

Inflation is kryptonite for the bond market for several reasons.

First, inflation undermines the capital of bonds as rising yields struggle and generally cannot keep up with price pressures. Rising returns mean falling prices.

When inflation rises, it means that future interest payments made for holding the bond are worth less.

Powell said the recent jump in earnings was “remarkable and caught my eye” but did not raise any alarms. Instead, he said he was only concerned about “disorderly conditions” in the market, which he did not identify as applicable, even though returns were at their highest level since the pandemic began.

Even if inflation rises, Powell and other Fed officials say they are satisfied with exceeding their 2% target until the labor market shows a full and inclusive recovery in terms of income, gender and race.

Wall Street was looking for evidence of policy changes being made by the Fed. Rather than go looking for rate hikes, some economists and investors are looking for the Fed to change the makeup of their monthly asset purchases.

One option would be to sell short-term bills of exchange and buy longer-term debt securities to increase short-end yields and lower them further over time to flatten the yield curve. This is known as an Operation Twist.

Investors fear that in the event of inflation, the Fed may have to catch up again by raising interest rates. Stock market investors also dislike rising interest rates as they make it more expensive for companies to borrow and put debt-laden companies that have become dependent on low interest rates at risk.

“In terms of financial conditions, it will be up to the Fed to see if they tighten further. The more cautious they become in the face of market expectations of higher inflation, the more financial tightening we will see,” wrote Peter Boockvar, chief investment officer at Bleakley Advisory Group.

Boockvar added that Fed officials “have placed themselves in a difficult position” and must hope that inflation does not hit the 2% target before employment does too.

“If so, they have a problem because they will be afraid of higher rates if they continue to focus on employment like that,” he said.