Chief Economist’s note: Fed maintains control of the markets.

US inflation is officially at 5% and the core inflation that strips out most volatile items is at 3.8% - the highest since early 90’s. You’d think that wouldn’t be a good news. Indeed markets were concerned about higher inflation back in February and then even pessimists did not expect CPI much above 4%. Now as the reality has turned out to be harsher both stocks and bonds are rallying in euphoria. Where’s the logic in that?

Well, our long-time readers should know that the logic in in flooding the markets with dollar as we first highlighted the issue in early April. The US Treasury decided to trim its cash position and starved the markets with new t-bill issuance and the Fed obviously keeps printing at full pace, adding to over liquidity. NY Fed reverse repo operations are at record levels, reflecting ever increasing liquidity. Why would investors sell stocks or bond only to struggle with investing their cash at 0%?  

Record reverse repo operations reflect record overliquidity – a precondition for all the market moves that we see right now. Source: Fred

Back in April I was also trying to figure out what the plan is given that the Treasury would need to start borrowing heavily from Q3 to finance record deficit. While it’s still not yet entirely clear, it looks like they wanted to blunt the impact of inflation spike. Record overliquidity plus the “transitory” talk disoriented markets and helped the Fed maintain control.

Obviously no one knows what the endgame to this is. We have never had the Fed so ignorant to inflation risks. If the transitory theory actually works maybe the Fed can actually ADD to QE at some point to help deficit financing? But what if it does not? At which point something breaks? We will not find out before the summer I’m afraid. So far expect the Fed to try and delay any tightening as much as they could.