Fed Punts on Interest Rates, Again, as Bond Yields Grow and Inflation Simmers

 Economists seem split on whether major inflation is coming as the Federal Reserve once again backed away from raising interest rates, sending bond markets higher.

Pedestrians pass the New York Stock Exchange in New York on Tuesday. (AP Photo/Frank Franklin II)

MANHATTAN (CN) — The week was a mixed one for stocks, but it was very good for bonds, which saw yields rise significantly as inflation concerns continue to bubble up.

Earlier in the week the Dow Jones Industrial Average glanced past the 33,000-point mark, but it shed some of those gains to close out a week at 32,628 points, a 150-point loss. The S&P 500 also fell slightly, decreasing 31 points for the week, as did the Nasdaq by dropping about 100 points.

At the bond market, however, investors appear to be betting that inflationary pressures will become a longer-term issue.

Bond yields once again rose significantly Thursday, with the yield on 10-year Treasuries hitting 1.75%. By the end of trading on Friday, the 10-year note had dropped to about 1.72%.

As a result of the Fed’s actions and a “brighter economic outlook,” Capital Economics has revised its forecast for 10-year Treasuries to 2.25% by the end of the year and 2.5% by the end of 2022, up from its previous 1.75% forecast by the end of next year.

“With another large spending package focused on infrastructure on the horizon later this year, U.S. fiscal policy poses an upside risk to our already above-consensus forecast for U.S. growth,” wrote Jonas Goltermann, a senior economist at Capital Economics. “And given that we expect the output gap in the U.S. to close later this year, we think that inflation will soon rise above 2% and stay a bit above that level even after pandemic-related base effects drop out.”

The Federal Reserve has caused some consternation among experts by downplaying the threat of inflation. In remarks following the Federal Open Markets Committee meeting on Wednesday, Chairman Jerome Powell noted that inflation remains below the 2% target set by the central bank despite recent price increases due to supply bottlenecks.

“However, these one-time increase in prices are likely to have only transient effects on inflation,” Powell said, pointing to a 2.4% median inflation projection this year by FOMC participants.

In its economic forecasts, the committee expects core inflation to reach as high as 2.3% this year, then drop down to a range of 1.9% to 2.1% in 2022 and 2% to 2.2% in 2023.

The FOMC also now predicts, however, that the U.S. economy will grow by 6.5% this year — the fastest in about 40 years. As a result, the central bank states it will not hike its interest rates until 2023 at the earliest, stating inflation would have to rise above 2% on average for a long period of time first.

“So when we see that we’re on track, when we see actual data coming in that suggests that we’re on track to perhaps achieve substantial further progress, then we’ll say so,” Powell told reporters after the meeting. “The fundamental change in our framework is that we’re not going to act preemptively based on forecasts for the most part.”

A number of leading economists also say not to fret too much about long-term inflation, predicting it will likely ease in 2022 as energy prices normalize.

“There is no doubt that supply-chain constraints have created serious bottlenecks in a variety of commodity prices while fiscal support payments have kept demand steady, creating a spike in input costs that has the markets worried,” wrote Boris Schlossberg of BK Asset Management in an investor’s note.

Some of these supply-side inflation pressures are already appearing in some economic data. The latest Empire State Manufacturing survey shows input prices gaining at the fastest pace in nearly a decade, rising 7 points to hit 64.4 on the index.

Additionally, while the Philadelphia Federal Reserve’s manufacturing index rose to 51.8 for the first half of this month — nearly a 50-year high point — the prices paid index is at its highest mark since March 1980.

Schlossberg notes that “demand-driven inflation is almost always temporary as supply often rises to meet demand,” and that “this is especially true now given the amount of spare capacity available as production comes back on line.”

The current situation is more akin to a lack of demand due to the coronavirus than the infamous inflation of the 1970s, which was caused by crop failures and then two oil shocks, Schlossberg said.

Another encouraging sign comes from Corporate America, which could see a record year. According to an analysis by economist Lydia Boussour at Oxford Economics, the stage is set for a 15% increase in corporate profits this year, marking the fastest gain in more than 10 years.

“As the rollout of Covid vaccines accelerates, generous fiscal transfers from the American Rescue Plan and firming employment will help unleash pent-up demand, fueling a summer boom in consumption and economic activity,” she wrote, predicting a double-digit increase in corporate revenue growth this year.

Boussour cautioned against too much optimism, though, noting that “the prospect of tighter labor market conditions and rising input costs this year, and the fact that margins have remained historically high, point to limited upside.”

Things for small businesses are also looking up, but they may face a longer slog recovering. A survey of small businesses by the U.S. Chamber of Commerce earlier this week found that 6 out of 10 small businesses predict it will take at least six months for the economy to get back to normal.

The chamber noted more than 100,000 small businesses have closed their doors due to the pandemic.

The outlook on the virus continues to brighten somewhat, despite still-high daily cases. While there have been about 30 million cases of Covid-19 in the United States and more than 539,000 deaths, according to data compiled by Johns Hopkins University, vaccinations are being rolled out in a quicker fashion.

The United States now ranks fifth worldwide in terms of the number of vaccine doses administered per 100 people of the total population. More than 151 million doses have been delivered to U.S. citizens, and 40 million Americans have been fully vaccinated so far, the U.S. Centers for Disease Control and Prevention states.

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