All eyes on Fed as it walks inflation-recession tightrope

CPI grew 9.1% in June

Tom Eckett

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The latest inflation data coming out of the US has created a serious headache for policymakers at the Federal Reserve who risk tipping the global economy into a recession by the end of the year.

Last Wednesday, the Labor Department revealed the Consumer Price Index (CPI)grew 9.1%year-on-year in June, up from 8.6% in May and crucially above economist predictions of 8.8%, while core CPI was 5.9%.

This figure is the largest jump since November 1981, driven mainly by energy prices that have skyrocketed this year.

In reaction, the US Treasury yield curve inverted to its highest level since 2000 following the ‘dot-com’ bubble with two-year Treasuries rising nine basis points (bps) to 3.13% while 10-year Treasuries fell five bps to 2.91% on 13 July, a 22bps spread.

An inverted yield curve is a leading indicator of a downturn in the US economy having successfully signalled every recession over the past 50 years.

All eyes now turn to the Fed’s Federal Open Market Committee (FOMC) meeting on 26-27 July where the chances of a 1% interest rate hike have risen significantly while a 0.75% increase is now a certainty.

With inflation once again surprising to the upside, the US central bank has no choice but to counter by raising rates despite the impact it will have on the economy's growth.

As Caleb Thibodeau, senior associate, global capital markets, at Validus Risk Management, said: “This is bad news for [US President Joe] Biden and really bad news for the Fed, which would be handcuffed to continued hikes regardless of growth deterioration or market performance.

“The Fed’s directive is to break inflation at all costs and only after that will it return to considering growth, labour markets.”

As a result, the chances of a recession have risen significantly with Fed chair Jerome Powell focused on his mandate of bringing inflation back down to the central bank’s 2% target despite political pressure from the Biden administration.

Powell previously warned in June that “further surprises could be in store” as the central bank looks to grapple with 40-year high levels.

Tiffany Wilding, US economist at PIMCO, said a faster pace of monetary tightening has increased the firm’s confidence in its recession call.

“We think US recession is more likely than not over the next 12 months and with more restrictive monetary policy now expected, the size of the contraction is also likely to be more severe.”

Her views were echoed by Research Affiliates’ founder Rob Arnott and research head Campbell Harvey who warned the Fed’s “tardiness in tackling inflation” has significantly increased the chances of it overreacting to current levels.

“The Fed has not had to deal with serious inflation in the past 40 years and the responses adopted now will likely slow the economy,” they continued. “It is very late to the game because the board members were in denial for a long time.

“The Fed’s track record on forecasting, whether the economy or inflation, is rarely better than a Ouija board. If we are not already slipping into recession, we see a substantial probability that a recession could start in late 2022 or 2023.”

In response, ETF investors are rotating into longer-duration US Treasuries in expectation of stronger performance during a recession.

Highlighting this, the iShares $ Treasury Bond 7-10yr UCITS ETF has seen $224m inflows over the past week, as at 16 July, while investors pulled $157m from the iShares $ Treasury Bond 0-1yr UCITS ETF, according to data from ETFLogic.

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