The bond market sold out on Thursday when Jerome Powell, chairman of the Federal Reserve, expressed little concern about inflation and gave no indication of the policy changes ahead.
In an exchange with the Wall Street Journal, the central bank leader acknowledged that an economy recovering from the depths of the Covid-19 pandemic is facing price pressure.
But he also dismissed them as mostly ‘basic effects’. In other words, prices in the next few months will look high, but only compared to last year, just when the pandemic started and the inflationary pressure fell through the floor.
In addition to indications of full employment, Powell said: “We want to see inflation sustainably above 2% and we want to be on track for inflation to rise sustainably above 2%.”
“There’s just a lot of ground to cover before we get to that,” he added.
Bond markets sold during his commentary, yielding higher returns as prices and returns move in opposite directions. Shares also tumbled, bringing the Dow industries down more than 600 points.
Inflation is kryptonite for the bond market for several reasons.
In the first place, inflation defends the capital of bonds, as rising yields struggle and usually cannot keep up with price pressure. Rising returns mean falling prices.
Furthermore, if inflation rises, it means that future interest payments you receive for keeping the mortgage are less valuable.
Powell said the recent yield jump was “remarkable and caught my attention,” but raised no alarm. Instead, he said he would only worry about ‘disorderly conditions’ in the market, which he says is not the case, although yields are at the highest levels since the pandemic began.
Even if inflation does rise, Powell and other Fed officials say they are content to push it above their 2% target until the labor market shows a full and inclusive recovery by income, gender and race.
Wall Street was looking for an indication of Fed policy adjustments. Instead of seeking rate hikes, some economists and investors are seeking the Fed to change the composition of its monthly asset purchases.
One option would be to sell short-term accounts and buy longer-term notes in an effort to increase yields on the short side and lower them longer to flatten the yield curve, in a process known as Operation Twist.
Investors are worried that the Fed will have to catch up again with higher rates if inflation does occur. Stock market investors also do not like rising interest rates as it makes it more expensive for businesses to borrow and risk debt-laden companies that have become dependent on low rates.
“As for the financial conditions, it will depend on the Fed or tighten it further. The more dull they get in light of the market’s expectations of higher inflation, the more financial tightening we will see,” said Peter Boockvar, chief executive. investment officer at Bleakley Advisory Group.
Boockvar added that Fed officials “put themselves in a difficult situation” and that they should hope that inflation does not reach the 2% target before jobs also reach their target.
“If it does happen, they have a problem because they will be afraid to confront it with higher rates if they stay so focused on employment,” he said.