The economic re-opening drives inflationary pressures while COVID-19 weighs on markets

Recovery in US and Europe
Key takeaways
Last week’s US Consumer Price Index print was higher than expected
Investors immediately assumed that the Fed would raise rates more quickly, causing the yield curve to flatten.
I don’t believe the inflation data point suggests the Fed will hasten raising rates
The Fed’s dual mandate is focused not just on maintaining price stability but also achieving full employment — and the data shows we still have a long way to go before we get there.
The ECB is altering its monetary policy for the first time in nearly 20 years
The ECB seems to be following in the Fed’s footsteps in terms of becoming more flexible on an overshoot of target inflation so long as it is moderate and temporary.

I just returned last week from travels in the South and Midwest of the United States with my daughter and her basketball team. My time was spent in several different cities where their tournaments were being played, and I was sadly struck by how slowly the economy has re-opened in those cities. In walking around, I saw a number of empty storefronts where shops and restaurants had gone out of business as a result of the pandemic. I saw a movie theater that had shuttered its doors in March of 2020, a heavy layer of dust covering some leftover cardboard popcorn buckets like the ashes of Pompeii (apologies for being dramatic but these are heartbreaking scenes). This is the “economic scarring” that Federal Reserve (Fed) Chair Jay Powell talked about. And this scarring has occurred in many countries around the world.   Granted this could have been far worse had it not been for a significant amount of fiscal stimulus, but damage has been done.

This economic scarring can contribute to inflationary pressures. For example, because some restaurants have closed, there are fewer restaurants in operation. That means that calling for dinner reservations for the basketball team became a Herculean task. When we were lucky enough to find tables at a restaurant, we discovered that the cost of meals was much higher than two summers ago when we were last at tournaments and dining out. And of course, a key reason for the price increases has been that restaurants and stores are having difficulty sourcing labor — as evidenced by the somewhat desperate “help wanted” signs posted around various cities and towns across America. It will take time for economies to adjust and work through the economic dislocations that have occurred.

And that brings me to the US Consumer Price Index (CPI) print released last week. It was higher than expected — and was met with concern by many pundits and strategists. I can’t say I was terribly surprised. We are in an incredibly unique time in economic history, and so I believe all bets should be off about data such as inflation. I continue to believe that much of the rise in inflation we are seeing is temporary. To put it simply, inflation occurs when too much money chases too few goods and services. The re-opening of the economy post-pandemic is an extraordinary event that has created a colossal burst of inflation, but like the pandemic itself, I expect it to only last temporarily. For example, one key driver of this higher-than-expected CPI report was used cars. Higher used car prices are a result of the post-pandemic environment we are in. They are a function of base effects — far fewer used cars were being sold last year at this time — plus difficulty purchasing new cars because of supply chain disruptions as well as a change in transportation choices given ongoing health concerns (i.e., a preference for avoiding mass transit).

But the reaction by many, as evidenced in the behavior of the 10-year US Treasury yield, was not to drive up longer-term rates because of expectations that inflation will be higher. Instead the yield curve flattened as investors immediately assumed that the Fed would raise rates more quickly, and that such action would dampen economic growth. However, I don’t believe the inflation data point gives any reason to expect that the Fed will hasten raising rates. Last year the Fed adopted a new inflation targeting policy, and I really believe it is a paradigm shift. Put simply, it appears the Fed is going to be more tolerant of the overshooting of inflation.1 And let’s not forget the Fed has a dual mandate; it’s not just about maintaining price stability but it’s also about achieving full employment. And as we know from the data, we are still far from full employment.  Finally, concerns are also mounting about what the spread of the COVID-19 Delta variant could do to slow the global economic recovery; we have to recognize that if it negatively impacts the US economy, it could easily push back the Fed’s tightening timeline.

Speaking of new monetary policy, the European Central Bank (ECB) just completed an exhaustive monetary policy review and has made the decision to alter its monetary policy for the first time in nearly 20 years. The ECB reaffirmed that forward guidance, quantitative easing, and targeted long-term refinancing options (TLTROs) will remain policy tools. It also included a climate action plan intended to ensure that the ECB supports environmental responsibility and fights climate change through monetary policy tools. For example, the ECB will adjust “the framework guiding the allocation of corporate bond purchases to incorporate climate change criteria, in line with its mandate.”2

What’s most interesting right here and now is that the ECB seems to be following in the Fed’s footsteps in terms of becoming more flexible on an overshoot of target inflation so long as it is moderate and temporary (although the ECB’s policy is a weaker version of the Fed’s). This means the ECB is likely to provide support to the eurozone economy for longer in an economic crisis, rather than acting preemptively to head off inflation, and running the risk of a premature tightening that chokes off recovery.

For the recovery at hand, we think this means the ECB will look through the current rebound in inflation, and continue with asset purchases and negative rates for months to come. This would be very different from its decisions during the 2008 global financial crisis and the 2010 eurozone crisis. Both times, it raised rates in response to early signs of inflation, probably making each downturn worse than it needed to be. We would expect this shift in the ECB’s approach to translate into greater market confidence, holding in sovereign spreads and supporting risk assets through the unfolding economic rebound. It will be interesting to see how the ECB begins to implement its policy change at this week’s meeting.

Finally, I think it’s important to address the current global stock market sell-off that is underway. The 10-year Treasury yield has dropped significantly as “risk off” sentiment permeates global markets. As I have said before, we shouldn’t be surprised that stocks are finally experiencing losses. I have been waiting for this given that it has been a long time since we saw a large sell-off. And it stands to reason that we would experience one now as COVID-19 jitters have re-emerged with the spread of the Delta variant and as the Fed prepares to transition to the start of monetary policy normalization with an anticipated announcement on the start of tapering soon. But that is no reason to panic; neither one of our tail risk scenarios that I articulated in our mid-year outlook has come to fruition. I believe the bull market is far from over — it is just catching its breath. Stay calm, stay diversified, and for those with cash on the sidelines, look for buying opportunities.

With contributions from Arnab Das, Global Market Strategist, EMEA.


  • 1 According to the Federal Reserve Bank of Cleveland, the Federal Open Market Committee, a flexible average inflation-targeting regime will seek to achieve a 2% inflation target, on average over time. This new approach implies that if inflation has been running persistently below the target, the FOMC will likely aim to achieve inflation moderately above the target for some time to return the average to 2%.

    2 European Central Bank, “ECB presents action plan to include climate change considerations in its monetary policy strategy,” July 8, 2021

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  • This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities.

    Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals, they are subject to change without notice and are not to be construed as investment advice.

    The consumer price index (CPI) measures change in consumer prices as determined by the US Bureau of Labor Statistics. Core CPI excludes food and energy prices.

    The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity.

    Base effect is the impact that a choice of a basis of comparison or reference can have on the result of the comparison of data.

    Quantitative easing (QE) is a monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective.

    Risk off refers to price behavior driven by changes in investor risk tolerance; investors tend toward lower-risk investments when they perceive risk as high.

    Diversification does not guarantee a profit or eliminate the risk of loss.

    The opinions referenced above are those of the author as of July 19, 2021. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.