Singapore, Individual

Change chevron_right

No way out? Why the Fed may be trapped

Brij Khurana, Fixed Income Portfolio Manager
June 2021

The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed.

The job gains cited in the May 2021 non-farm payrolls release fell well short of what the market had hoped. A fluke? Maybe, but this disappointing jobs report suggests to me that US inflation dynamics are beginning to shift from “demand-pull” to “cost-push” inflation.

The perils of cost-push inflation

Demand-pull inflation is the upward pressure on prices that occurs when aggregate demand outpaces aggregate supply. Cost-push inflation, by contrast, is caused by increased costs for raw materials, wages, and other inputs to production. The latter type of inflation tends to be much more harmful to an economy, as it forces companies to choose from among three distinct (and all undesirable) options:

  1. Seek to cut their capital costs elsewhere to preserve profit margins
  2. Invest in productivity-boosting solutions to reduce their labor costs
  3. Pass their increased costs on to consumers in the form of higher prices

The most probable scenario, in my judgment, is option 3. Typically, this not only leads to broadly rising inflation for an economy, but also adversely affects economic growth in that higher inflation alters consumer behavior by blunting demand, particularly on non-essential goods and services. For example, given today’s lofty lumber prices, many households have postponed discretionary home renovations.

Bottom line: Cost-push inflation can erode corporate profit margins, eat into consumer budgets, and contribute to lower overall real growth.

Implications for monetary policy

If I am right that the US economy is entering a new phase that will be more subject to cost-push inflation, what does this mean for the future path of US monetary policy? Perhaps quite a bit.

According to the US Federal Reserve (Fed)’s revised monetary policy framework, for the Fed to raise interest rates, it will need to observe both very low unemployment and average inflation above 2% for a sustained period. The shifting inflation dynamics may test the Fed’s resolve by making its dual objectives harder to achieve. Inflation is likely going to be “stickier” than it was last cycle and the unemployment rate structurally higher, given the massive COVID response by fiscal authorities and structural changes to the labor supply.

In a nutshell, I see the Fed as being trapped by its own devices. Its new policy framework subjugates its inflation mandate to its unemployment goal, which may well be unattainable. And as noted, inflation is likely to be sticky. One troubling possibility worth considering: What if cost-push inflation starts cutting into corporate profits, causing the US stock market to begin underperforming? Then the Fed could be in an even bigger bind, where financial conditions are tightening at the same time that its employment goal remains out of reach.

Investment takeaways

  • US dollar: I’ve been negative on the US dollar (USD) for a few years now and believe May’s underwhelming job gains could be a catalyst for further depreciation. I see three other reasons to be bearish on the USD: An expensive real exchange rate, rising current-account deficits, and the Fed’s new revised policy. A weaker dollar going forward could translate to relative strength in some other global currencies.
  • Long-end US real yields: I don’t have a lot of conviction right now in accurately forecasting the direction of the US nominal-bond market. However, there may be an opportunity in long-end (30-year) US Treasury real yields, which I suspect could outperform their nominal-bond counterparts if (as I believe) the next upward move in US rates comes from rising inflation expectations.
  • Non-US duration markets: I believe non-benchmark, total-return-oriented bond investors should scour the globe for non-US duration markets that appear to offer more compelling opportunities than the US nominal-bond market. The developed markets of Canada and Norway are two that I think are worth a look these days.
  • EM local bonds: Another potentially attractive source of global duration is in emerging markets (EM) local bonds. EMs where I currently like both the rate and currency markets include Mexico, Russia, Brazil, and Indonesia.
Key topics and themes
Inflation
Fixed Income
USA
Written by
Khurana_Brij_7345_w316
Brij Khurana
Fixed Income Portfolio Manager
Boston, USA

RECOMMENDED FOR YOU

DISCLOSURES

Past results are not necessarily indicative of future results and an investment can lose value. Funds returns are shown net of fees.
Source: Wellington Management

© 2021 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. The Overall Morningstar Rating for a fund is derived from a weighted average of the three, five, and ten year (if applicable) ratings, based on risk-adjusted return. Past performance is no guarantee of future results.

The content within this page is issued by Wellington Management Singapore Pte Ltd (UEN: 201415544E) (WMS). This advertisement or publication has not been reviewed by the Monetary Authority of Singapore. Information contained on this website is provided for information purposes and does not constitute financial advice or recommendation in any security including but not limited to, share in the funds and is prepared without regard to the specific objectives, financial situation or needs of any particular person.

Investment in the funds described on this website carries a substantial degree of risk and places an investor’s capital at risk.  The price and value of investments is not guaranteed and may fall or rise. An investor may not get back the original amount invested and an investor may lose all of their investment. Investment in the funds described on this website is not suitable for all investors. Investors should read the prospectus and the Product Highlights Sheet of the respective fund and seek financial advice before deciding whether to purchase shares in any fund. Past performance or any economic trends or forecast, are not necessarily indicative of future performance. Some of the funds described on this website may use or invest in financial derivative instruments for portfolio management and hedging purposes. Investments in the funds are subject to investment risks, including the possible loss of the principal amount invested. None of the funds listed on this website guarantees distributions and distributions may fluctuate and may be paid out of capital. Past distributions are not necessarily indicative of future trends, which may be lower. Please note that payment of distributions out of capital effectively amounts to a return or withdrawal of the principal amount invested or of net capital gains attributable to that principal amount. Actual distribution of income, net capital gains and/or capital will be at the manager’s absolute discretion. Payments on dividends may result in a reduction of NAV per share of the funds. The preceding paragraph is only applicable if the fund intends to pay dividends/ distributions.  Performance with preliminary charge (sales charge) is calculated on a NAV to NAV basis, net of 5% preliminary charge (initial sales charge). Unless stated otherwise data is as at previous month end.

Subscriptions may only be made on the basis of the latest prospectus and Product Highlights Sheet, and they can be obtained from WMS or fund distributors upon request.

This material may not be reproduced or distributed, in whole or in part, without the express written consent of Wellington Management.