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Transitory or not, inflation signals shake the markets

(Bloomberg) – Time and again, Federal Reserve officials have asserted that any spike in inflation this year would be transitory. However, traders in the financial markets are not so sure.

Investors have become obsessed with widespread signs of upward price pressures as commodities such as copper and lumber surge to record highs, and the bond market’s expectation for inflation in the next decade rises to a high of eight years. The focus is triggering swings in the stock market, driving the Cboe volatility index to its highest level since March on Tuesday. The most recent round of U.S. corporate earnings reports put the word inflation back in vogue, with an 800% increase in its use over the previous year, according to Bank of America Corp. Even last week’s payroll report, which showed that the US added in April only about a quarter of the jobs that economists hoped, it is seen as a sign that companies will have to raise wages to attract more unemployed workers into the workforce.

“Inflation risk is what we want to see here,” Savita Subramanian, Bank of America’s head of capital and quantitative strategy, told Bloomberg Television on Friday. “I don’t know if it will be transitory.”

US consumer prices posted their biggest increase since 2009 in April, amid a record rise in used car costs. This large rise indicates an accumulation in inflationary pressures, as strong demand gives companies the freedom to pass on the higher costs.

Inflationary fears are a political threat to President Joe Biden’s plans for major new spending, particularly after a disappointing jobs report on Friday.

But policymakers are sticking with it. Even the most restrictive members of the Fed have weighed in in recent weeks to say that inflation is unlikely to spiral out of control despite unprecedented government spending in response to the coronavirus pandemic. Both Fed Chairman Jerome Powell and a top economic adviser to the Biden Administration have said that the inflation now seen in certain sectors of the economy is “transitory.”

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That description raises an important question: how long does “transitory” mean? The answer is probably unknown at this point, but past recessions provide some clues.

Commodities after the recession

If the latest price increase is largely driven by commodities, then it is a question of how long those input prices will continue to rise. Using the 2009 economic rebound as a roadmap, demand for raw materials, and ergo their prices, skyrocketed for two years and drove global inflation until commodity markets peaked.

Those price increases were largely driven by a massive Chinese infrastructure package. This time around, the US can play the role that China played more than a decade ago, as the Biden administration proposes billions of dollars in spending. According to this logic, “transitory” could mean two years.

However, raw materials such as wood and copper are not the only factors that will potentially drive inflation. Computer chips used in everything from cell phones to cars to refrigerators also play a role.

On the other hand, pent-up demand among those who cannot afford expensive items can be seen in rising US used car prices, said Sebastien Galy, a senior strategist at Nordea Investment Funds SA in Luxembourg. The Manheim Used Vehicle Value Index, which measures prices at wholesale auctions, shows they are now 20% higher than since late last year.

Breakevens

The bond market has absorbed all the pressure on prices, and the inflation expectations it reflects are influential in setting investors’ assumptions. The 10-year breakeven rates, a benchmark for expected inflation for the next decade, are close to their highest level since March 2013, at around 2.54%. Five-year breakevens reached 2.78% this week, their highest level since 2006.

Certainly not all market participants agree with the inflation signals coming from the bond market. Goldman Sachs Group Inc. and Pacific Investment Management Co. estimate that bond traders who set an annual inflation price close to 3% in the coming years will exaggerate the increased pressures.

Wage pressures

Meanwhile, some investors, strategists and politicians have indicated that the real message from last month’s job creation rate, which was well below forecast, is that it will increase the cost of attracting more unemployed back into the job market. This is in part due to additional government unemployment benefits that make your previous wages less attractive. Any pressure to increase wages could affect the prices of goods and services, further increasing the rate of inflation.

Original Note: Transitory or Not, Signs of Inflation Are Roiling Asset Markets

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