Pimco's Wilding sees risk of inflation reigniting, prompting swift response by Fed

'We're monitoring risks in both directions: the potential for growth to stagnate, or for inflation to reignite,' said economist Tiffany Wilding

Just as investors are settling into the idea of no Federal Reserve interest rate cut soon, there's another scenario gaining some support with the potential to upset financial markets this year.It's the risk that inflation ends up rebounding, leaving policymakers in the position of needing to react quickly. In a note released to clients on Wednesday, economist Tiffany Wilding of California-based bond fund Pimco said "recent data have underscored how progress on inflation in 2024 may be slower and more nuanced than in 2023."Since December, investors have largely focused on the prospects of at least three quarter-of-a-percentage-point cuts in the Fed's benchmark rate in 2024 and on decelerating inflation, though policymakers have pushed back against the idea that they would start to ease policy as soon as March. Now, officials are looking for a sustainable decline in inflation toward 2% before they're ready to act, which will likely take more time.What isn't being fully factored into financial markets just yet is the possibility that the central bank might need to raise interest rates again, after having already lifted borrowing costs by more than five full percentage points since March 2022. Fed-funds futures are still mostly priced for at least five quarter-point rate cuts by December. And when policymakers talk about eventually adjusting monetary policy, it's in the context of lowering - not raising - rates this year.Nonetheless, there's been some acknowledgment that the Fed's monetary tightening efforts to date haven't been enough to hold back the U.S. economy. Earlier this week, Minneapolis Fed President Neel Kashkari wrote in an online essay that the central bank's rate and balance-sheet policies "may not be as tight as we would have assumed," and that the so-called "neutral" level at which rates are neither accommodative nor restrictive may have increased. He stopped short of suggesting that another rate hike is needed, however, and mentioned the need to keep rates at their current levels of between 5.25% and 5.5%.A steady stream of data since last Friday's nonfarm payrolls report, which showed a higher-than-expected 353,000 gain for January, is only reinforcing the view that the economy isn't buckling yet. Meanwhile, annual core inflation based on the Fed's favorite indicator is trending toward 2%, but hasn't done so for long enough to leave officials confident. See also: Does January jobs report put interest-rate hike on the table? Probably not - but watch this space, says economistAt Pimco, Wilding said she's still holding out for the possibility of a soft landing for the U.S. economy. However, she said, the risk of sticky inflation looks "particularly pronounced in the U.S., where we believe growth could be more resilient than in other DM [developed-market] economies." "We're monitoring risks in both directions: the potential for growth to stagnate, or for inflation to reignite," Wilding wrote. "We also believe the Federal Reserve would likely respond swiftly and decisively to rising inflation. Central bankers don't want to repeat the price spikes of all too recent memory."

On Wednesday, financial markets appeared relatively calm after Federal Reserve Gov. Adriana Kugler said it is critical for inflation to return to 2%. All three major U.S. stock indexes DJIA SPX COMP closed higher, while Treasury yields finished little changed after a solid $42 billion auction of 10-year notes. And oil-price gains remained largely limited on the prospect of a potential ceasefire between Israel and Hamas in Gaza. Wilding isn't alone in her views. In January, James Solloway, chief market strategist and senior portfolio manager at Pennsylvania-based SEI (SEIC), warned that inflation "is far from dead" and said he doubts it can fall back to 2% "without some amount of pain." Brent Schutte, chief investment officer of Milwaukee-based Northwestern Mutual Wealth Management Co., described wages as " the one remaining ember that could reignite inflation."

-Vivien Lou Chen

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02-07-24 1629ET

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