So now, suddenly, out of nowhere, inflation has reared its ugly head, and the financial markets are starting to believe it.
On Wednesday the Labor Department reported that the consumer price index rose a higher than expected 0.5% in January, 2.1% compared to the year-earlier period. The all-important core rate, which excludes food and energy prices, rose 0.3% for the month, 1.8% versus a year ago. While not exactly hitting the Federal Reserve’s revered 2.0% annual inflation target, it was apparently close enough to create more jitters in the bond market, with the yield on the U.S. Treasury’s benchmark 10-year note immediately climbing seven basis points to 2.91%, its highest level in more than four years.
The very next day, Labor reported that the core producer price index rose 0.4% for the month and 2.2% year-on-year, which pushed up the yield on the 10-year another basis point, to 2.92%.
I’m not exactly sure why this recent surge in inflation should come as such a big surprise to anyone, but it surely has, witness the tremendous amount of volatility in the financial markets in just the past two weeks. The tipping point seems to have been the release of the January jobs report, the highlight of which wasn’t the change in nonfarm payrolls and the unemployment rate, which they usually are, but the 0.3% (2.9% annualized) growth in wages, which was the strongest year-over-year gain since June 2009.
That seemed to finally catch everyone’s attention that yes, contrary to what the Fed has been telling us for the past four years, inflation really does exist. Now we have more verification. And it’s probably only going to exacerbate.
And who do we have to thank for this new-found inflation? Why, the world’s central banks, of course, the same people who have been telling us that inflation is too low.
Yardeni Research put out an interesting report recently that shows just how much money the three major central banks – the Fed, the European Central Bank and the Bank of Japan – have flooded the markets with since the global financial crisis.
The Fed’s balance sheet has jumped from more than $4.4 trillion from less than $900 billion before the crisis, while the ECB’s has grown to more than $5.5 trillion from about $1.5 trillion.
The BOJ’s has increased to $4.8 trillion – that’s larger than the Fed’s balance sheet in actual dollars, in a much smaller economy – from about $1 trillion. As a percentage of local currency GDP, the BOJ’s balance sheet has grown the largest by far, accounting for nearly 93% of that country’s GDP; in 2007, before the crisis, the comparable figure was about 21%. By comparison, the ECB’s balance sheet accounts for about 38% of the euro zone’s GDP, up from about 12% ten years earlier, while the Fed’s portfolio equates to about 22% of U.S. GDP, up from about 6%.
What happens when those banks start trying to jam all that toothpaste back into the tube? We’re at the beginning – and only just the beginning – of finding out. As Goldman Sachs CEO Lloyd Blankfein said the other day, “Central banks around the world have been buying everything in sight, which is a blanket on volatility. That is stopping and is going to reverse.” That’s putting it mildly.
Unlike its colleagues abroad, the Fed has had the good sense and moral courage (a little, anyway) to at least start the unwinding process. The Fed ended its asset purchases back in 2014 and late last year announced it was going to allow the government bonds and mortgage-backed securities in its portfolio to start running off as they mature. That process began in November, with about $6 billion – which sounds like a lot, but is only a tiny fraction of the Fed’s total holdings, about one-tenth of 1% if my math is correct – coming off the books.
Meanwhile, the Fed’s counterparts in Brussels and Tokyo are still sitting on their hands. In October the ECB announced that it would reduce its monthly asset purchases by half, to 30 billion euros, beginning in January 2018, with the acquisitions scheduled to end in September, although it has hinted that it may extend the program beyond that. The BOJ continues its asset-purchase program and given no indication when it might end.
This is the unenviable situation Jerome Powell finds himself in as he takes the seat of Fed chair for the next four years. “We are in the process of gradually normalizing both interest rate policy and our balance sheet,” he said after his recent swearing-in. Not only will he have to do that without making volatility even worse, but he’ll also no doubt have President Trump tweeting him at all hours demanding to know why he’s trying to wreck the recovery.
The moral of the story is that interest rates are going up because the economy is finally growing strongly again. That’s a good thing. But it also means the long bull market in bonds is now over. Welcome to the new normal.
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George Yacik
INO.com Contributor - Fed & Interest Rates
Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.
