Did the US Federal Reserve just ring the inflation warning bell?

Is inflation back? If so, the US Fed has been very, very wrong….

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graph depicting inflation with the word written in the middle

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In 2021 so far, much of the discussion around the share market and investing in ASX shares have centred around inflation. Specifically, whether this economic scourge will rear its ugly head in the next year or two. February saw an intense reaction to this possibility, with many sectors that investors seemed to deem as highly exposed to future inflation, selling off sharply.

No sector was harder hit than ASX tech shares. Following a similar reaction over in the US, the S&P/ASX All Technology Index (ASX: XTX) fell a nasty 18% between 10 February and 9 March earlier this year. We can see this in action by looking at the Afterpay Ltd (ASX: APT) share price. Afterpay can be described as a ‘poster child’ of sorts when it comes to ASX tech shares. And boy, did it have a rough ride a few months ago. Between February and May, Afterpay shares fell almost 50% in value.

Inflation returns?

One of the factors that seem to be in play here was inflation fears. Financial markets typically respond to higher inflation expectations with an increase in the running yield government bonds are priced with.

In early 2021, a 10-Year US Treasury Note was priced with a yield of roughly 1%. By April, this had grown substantially to around 1.75% before sliding back over subsequent weeks to the ~1.45% we saw yesterday. But today, this yield has shot up again, back to 1.59% at the time of writing.

So what happened? The US Federal Reserve, that’s what.

According to a report in the Australian Financial Review (AFR) today, last night the Fed seemed to reign in its previous rhetoric surrounding inflation and its medium-term expectations on it. Previously, (as we’ve covered over the past few months), the Fed had strongly signalled that it expected that rates would not have to rise until 2023 or 2024, contingent on inflation running at 2% and the economy hitting something close to full employment.

But last night, the Fed seemed to change its tune somewhat. The AFR quotes US Fed chair Jerome Powell as stating the following:

Inflation has come in ahead of expectations in the last few months… Is there a risk that inflation could be higher than we think? Yes. There is a lot of uncertainty. We need to see how things evolve in coming months. This is an extraordinarily unusual time.

How have ASX shares reacted today?

This rather extraordinary statement came alongside some revised inflation expectations from the Fed. 3 months ago, the central bank was predicting US inflation of 2.4% for 2021. As of last night, the Fed now expects that number to hit 3.4%. That’s a pretty big revision over a 3 month period. The Fed has also revised its interest rate expectations, flagging the possibility of up to 2 rate hikes by 2023.

As you might expect, there has been a pretty substantial reaction to this update from financial markets. We’ve already covered the spike in US government bond yields. But we’ve also seen the US S&P 500 Index (INDEXSP: .INX) drop sharply last night in the news. It recovered slightly at the end of the day’s trading but still finished 0.54% lower.

The S&P/ASX 200 Index (ASX: XJO) is also dipping today and is down 0.47% to 7,351 points at the time of writing. The Aussie dollar has also been sold off. It was going for more than 77 US cents yesterday. Today, it has dropped to 76.24 US cents.

Markets tend to fear inflation mainly because of the higher interest rates that come with it. It might well have the potential to spoil the party the ASX 200 has been enjoying over June so far.

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Motley Fool contributor Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. owns shares of and has recommended AFTERPAY T FPO. The Motley Fool Australia owns shares of and has recommended AFTERPAY T FPO. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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