Mizuho daily – Inflation mood swing, oil dampener, FOMC minutes

By Vishnu Varathan, Head, Economics & Strategy, Asia & Oceania Treasury Department, Mizuho Bank, Ltd.,

Inflation Mood Swing?

Wall St extended and deepened losses with 0.6-0.9% drop in headlines-light brooding markets. Whether this mood swing is presumably triggered by inflation worries is debatable. But Lawrence Summers coming out swinging at the Fed for “dangerous complacency” for negligence on inflation risks and financial market stability notable tips debate over to diatribe.

What’s clear is that views on inflation risks are becoming increasingly polarised. In turn, posing as a potential source of financial market volatility given inflation’s endogenous role in valuations.

Ahead of FOMC Minutes, where no game-changer is expected, the Greenback is on softer footing; with sub-109 USD/JPY, EUR above 1.22, AUD testing 0.78 upside while USD/SGD tests below 1.33.

Inflation mood swings though could have a large sway in coming sessions.

Can Oil be an Inflation Dampener?

Right off the bat, this sounds like a ridiculous proposition. After all, concerns of spiraling inflation risks are largely derived from surging  commodity prices; from which oil is ostensibly not absolved.

But scrutiny reveals that oil’s supply-demand dynamics feeding into energy costs are likely to stabilize; looking past distortionary base effects (from sharp collapse in oil prices last year) that is. On the demand end, outbursts of price pick-up are likely to be moderated, if not contained, amid uneven global recovery as oil is durably motivated broad-based economic recovery.

Whereas, lags in the beaten down travel/hospitality sectors are set for a far more gradual resumption to normalcy. As for the supply side, painfully idled OPEC+ spare capacity means a quicker response to demand recovery, with US shale likely to catch up on sustained rise to loftier $70+ levels.

As such, the big picture is for oil prices to be robustly supported in the $60-80 range, not surge to $120-$130 2011 highs (much less, $140 highs of 2008). In inflationary terms, this is consistent with a transitory surge in oil inflation through late-2021 before moderating sharply.

Above all, oil has far greater sway on global inflation than any other commodity. Fact is, oil has significantly higher correlation to, and impact (amplitude and duration) on, inflation. And so, oil may turn out to be the unsung and under-appreciated inflation dampener (akin to one of its mechanical functions) o the commodity cost-push pressures obfuscating the inflation outlook.

FOMC Minutes: No Second Thoughts

Admittedly, US inflation overshoot backed by a raft of other solid data (from ISM to a host of activity data/sentiments survey) demand policy contemplation.

But these provocative spots of overheating are not decisive catalysts for a shift in the Fed’s dovish bias. The bar is much higher under flexible average inflation targeting.

What’s more there have been offsetting soft spots in other data points such as non-farm payroll, industrial activity and retail sales. And that is even after accounting for distortions and friction in supply-chains and markets amid unprecedented stimulus.

More importantly, as the Fed’s view of an uneven economy with loads of slack is vindicated at its core; given over 8mn jobs that the economy remains short on vis-a-vis pre-Covid).

Upshot being, the dovish reflex  expected in the Minutes resonates with lived realities. That is not to say that the FOMC is ubiquitously sanguine about leaving exceptional policy stimulus in place. Robert Kaplan for one has alluded to negative effects of excessive stimulus.

Nevertheless, Kaplan’s views on favouring a reduction of QE sooner rather than later, given its distortions, will probably prove to be a sole voice; even if it not an unjustified position. To be succinct, the Fed Minutes will reveal no second thoughts on maintaining exceptional accommodation under the framework that will allow some degree of “running hot”.

And so, UST yields may get more reprieve, if not some reversal, from last week’s bear steepening; insofar that the Fed manages to convince markets about dovish commitments. Especially if the message that QE-type operation are not a one-way (reduction) risk comes through. Meanwhile, USD may be on the back foot if inflation expectations out-pace yields.

Credit: Mizuho Bank Ltd