Inflation could come roaring back 1970s-style. Here are 4 reasons why markets should be concerned, according to Deutsche Bank.

A trader works on the floor of the New York Stock Exchange (NYSE) in New York, U.S., February 17, 2017. REUTERS/Brendan McDermid

It’s too early for the Fed to declare victory on inflation, Deutsche Bank warned.Thomson Reuters

  • There is still a risk inflation expectations spiral out of control, Deutsche Bank warned.

  • Strategists pointed to four reasons why stagflation risks remain present in the economy.

  • It’s too early for the Fed to sound the all-clear on inflation just yet, the bank said in a note.

There are signs that investors should be concerned inflation makes a comeback and takes a path similar to the 1970s, and that means the Federal Reserve can’t afford to declare victory just yet, according Deutsche Bank.

Strategists pointed to the possibility that the US and other economies could re-enter a period of stagflation, with consumers’ expectations for future inflation spiraling out of control. That could result in a period of high inflation and sluggish economic growth, a situation that slammed the economy during the 70s and early 80s.

Today, the US is showing signs a stagflation spiral could be avoided. Monetary policy has already been tightened dramatically, with the Fed having hiked interest rates 525 basis-points to slow surging prices. The central bank has also shed over $1 trillion of assets from its balance sheet, which has drastically reduced the amount of cash sloshing around in the market, helping to bring down asset prices.

Meanwhile, supply chain pressures and commodity prices, two big drivers of inflation, have largely subsided. Long-term inflation expectations also remain close to the Fed’s 2% price target, with 1-year and 5-10 year inflation expectations falling between 2%-4%.

“But now is not a time to get complacent and there are very strong reasons for caution,” strategists warned in a note on Monday.

Here are four reasons why markets should be concerned about a resurgence in inflation.

1. Inflation is still above target in every G7 nation

Prices have stayed well-above central bankers’ targets in most advanced economies. US inflation re-accelerated to 3.7% year-per-year in August, per the latest Consumer Price Index report, growing at a faster clip than the 3.2% price growth recorded in July.

2. A new price shock could easily unanchor inflation expectations

That’s because inflation has stayed above central bankers’ target for nearly two years, and still remains above pre-pandemic levels in the US and much of Europe.

“If there is another shock and inflation remains above target into a 3rd or even a 4th year, it is increasingly difficult to imagine that long-term expectations will repeatedly stay lower than actual inflation,” strategists said.

3. Economic growth is sluggish

Tighter financial conditions have begun to take a toll on the economy, and there’s little room for that to change.

Bonds yields surged last week as investors priced in higher-for-longer interest rates, which could raise borrowing costs on debt and hinder growth.

The US debt-to-GDP ratio has also soared well-above what it was in the 1970s, which limits the amount of fiscal stimulus that can be used to stoke economic growth.

Easing monetary policy to aid growth may also be out of the question, given how sticky inflation has proven to be.

4. The last stretch of the Fed’s inflation war is usually the hardest

It’s difficult to say when the Fed should begin easing monetary policy. As inflation inches closer to its target, markets put more pressure on the Fed to slash interest rates, as higher borrowing costs weigh heavily on asset prices.

That’s magnified by the fact that monetary tightening works with a lag in the economy, meaning rate hikes delivered 18 months ago may not have been felt yet. That all raises the risk the Fed could overdo it and push the economy into a recession, a key concern of markets over the past year.

“Over the past 18 months, there have been a lot of promising signs that a return to the 1970s can be avoided … but for the time being at least, it is too early to sound the all clear,” strategists warned.

Read the original article on Business Insider

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