Friday's Market Minute: What Is The Tolerable Level Of Inflation?

With last week’s strong U.S. jobs data and expected high levels of consumer and producer prices, bond yields have risen to their highest in more than three weeks. The Consumer Price Index for all items less food and energy rose 4.3% over the last 12 months, which was relatively in line with projections and the Fed’s narrative around transitory price pressures this year. From another angle, the New York Fed's latest Survey of Consumer Expectations shows another leap in inflation expectations. Both the median 1-year and 3-year look ahead consumer inflation projection hit a data series high of 4.84% and 3.87%, respectively.

These numbers indicate consumers do not believe inflation is transitory.

As equity investors, we must be mindful that stocks are typically sensitive to the level of bond yields, with lower yields making the potential returns from holding equities more alluring. Some analysts still expect the 10-year yield to reach 2% by year-end. Cautious investors are concerned that the rise in yields eventually prompts an overdue market correction. For risk assets, it’s generally not so much the level of yields that matters, but the magnitude of how quickly they rise.

As the economic backdrop gradually improves, renewed debate fires up between Fed officials about the appropriate pace to remove its support. The past week has marked a turning point, with a growing number of central bankers making a case for a swifter retreat from financial markets than many initially expected. At the same time, Fed watchers are struggling to get to grips with a new monetary framework under which the central bank has said they’ll allow inflation to drift above their 2% goal for a time. Right now, the most important macroeconomic question being pondered is at what level does inflation alter the intertemporal investment decisions made by business leaders and permanently alter consumer purchasing patterns?

Inflation in the U.S. has hit levels not seen in decades. It’s clear the Fed thinks the current inflationary bump is transitory and therefore tolerable for corporations and households alike. Global supply chains and technological changes manifest over the years to induce a deflationary impact on the economy and can do little to ameliorate the shift in prices that quickly evolved since the pandemic recovery. Currently, little is known about how long the economy can tolerate general price inflation above 2% before profit forecasts become questionable, and consumers are challenged in spending beyond non-discretionary needs without meaningful wage growth.

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