On My Mind: Inflation: Don’t You (Forget About Me)

The US Federal Reserve finally acknowledged inflation is not a “transitory” problem and signaled a greater degree of concern; but investors seem to think that the Fed will blink when markets balk. With consumer inflation at multi-decade highs and COVID-19 risks still alive, what’s next for the monetary policy response—and market implications—as we move into 2022? Our Fixed Income CIO Sonal Desai shares her views.

The Federal Reserve (Fed) finally acknowledged that high inflation is not transitory—but markets believe its resolve to fight it is.

It was high time for the Fed to recognize we have an inflation problem on our hands. Already with the June release, when US Consumer Price Index (CPI) inflation rose above 5%, I had noted that significant price increases were not limited to a few outliers but had spread to several goods and services categories.

Since then, it’s become even clearer that inflation pressures are broad-based and not just due to base effects: core CPI reached 4.6% year-over-year (Y/Y) in October and has been at or above 4% for five consecutive months. Alternate measures of inflation like the San Francisco Fed’s Cyclical Core PCE and the New York Fed’s Underlying Inflation Gauge have also risen sharply.1 Headline inflation jumped to a 31-year high of 6.2% Y/Y.

Over a year ago, we at Franklin Templeton Fixed Income were already an outlier with our significantly above-consensus inflation call. Four months ago, I again flagged the risk that markets and policymakers might still be underestimating inflation, and I pointed to two factors: the likelihood that high inflation would show a significant degree of inertia, and the dichotomy between consumers and businesses, who expected inflation to persist, and most financial investors who appeared convinced it would not.