Fed changes tune as inflation here to stay

New inflation data released this week has confirmed U.S. consumer prices rose by seven per cent and core prices rose by 5.5% in 2021, upending several economic outlooks that downplayed inflationary risks last year.

According to Brian Nick, Chief Investment Strategist at global investment manager Nuveen, inflation in 2021 was caused mostly by the positive demand shock from several fiscal stimulus measures and policies introduced in the first half of the year, as well as the ongoing supply chain bottlenecks impacting industries worldwide.

The U.S. Federal Reserve System (Fed) has also shifted their mindset regarding inflation management, with Fed Chair Jay Powell referring to inflation as a “severe risk” in his confirmation hearing last week despite discussing “transitory” inflation only four months prior.

“Supply chain issues aren’t going away fast enough, and durable goods prices continue to rise when the Fed and others likely expected them to be correcting by now,” Nick said, as an explanation for the Fed’s pivot.

“The unemployment rate has dropped really far, really fast and the recovery in labour force participation has been disappointing.”

“The Fed is worried about a high inflation mentality settling into the economy. Goods prices are still high and rising, while sharply increasing wages in some areas are pressuring profit margins and, potentially, prices.”

Nick also warned that the Fed’s reformed outlook on inflation may lead to a rate hike earlier than originally expected as soon as March and to qualitative tightening (QT) as soon as the second half of the year.

“QT occurs as the Fed allows maturing securities to roll off its balance sheet without replacing them, draining liquidity from the financial system and tightening overall conditions,” he said.

“The magnitude of this potential tightening remains unclear, because the Fed has not said how fast it will allow securities to roll off or what the terminal size of its balance sheet should be.

Nick also confirmed that this change in the Fed’s communication has not altered Nuveen’s outlook for broader markets in 2022, with expectations still on strong economic growth and benign disinflation to drive real interest rates higher and help underperforming segments to outperform.

“The Omicron variant remains a wild card for economic growth,” Nick said.

“Countries that attempt to contain the virus via strict mitigation measures could suffer economically in the first quarter as COVID waves ripple through the globe.

“Omicron and concerns about policy tightening add to our conviction that 2022 will be ‘slower’ than 2021 ‘…but still pretty fast’.”