Has the inflationary dragon really been slain?

The risk that inflation could remain sticky—or even rise again—continued to haunt markets this week. The main catalyst was the U.S. dockworkers’ strike. It briefly closed ports across the eastern seaboard and Gulf Coast, before a deal was reached on Thursday to suspend the strike until January to provide time to negotiate the new contract. Many investors had worried a prolonged work stoppage could have led to a shortage of consumer and industrial goods which, in turn, could drive-up prices and influence the Federal Reserve’s rate-cutting cycle.

U.S. inflation fell to 2.5% in August, providing space for the Fed to slash interest rates by 50 basis points in September, beginning its first easing cycle since the Covid-19 pandemic. The central bank is expected to cut rates again in November, with further reductions forecast next year. However, Federated Hermes Limited Portfolio Manager Martin Todd says it’s “far from a done deal” that rates will continue to decline.

“After the presidential election, there is the potential for inflation to persist given the policies both candidates are proposing. It is certainly not a given that rates will keep falling,” Todd says.

One factor that could increase prices is the imposition of tariffs by the new administration following the election. Republicans, in particular, have campaigned on aggressively increasing trade tariffs, particularly against China, whose central bank announced a sweeping stimulus programme last week. Many economists anticipate that a second Trump presidency would prove inflationary on the back of a sharp rise in trade tariffs as well as a crackdown on immigration.

“Even a small increase in inflation could influence the Fed and cause it to pause the rate-cutting cycle,” says Ann Ferentino, Portfolio Manager for Fixed Income at Federated Hermes.

An additional concern for policymakers is the further escalation of tensions in the Middle East, which saw Iran fire a barrage of ballistic missiles at Israel on Tuesday night, leading to a sharp spike in the VIX Index and sending the price of oil to above $75 a barrel.

Positive money market flows

The Fed rate cut last month reduced the federal funds rate to a range of 4.75% to 5%%, but predictions that policymakers’ easing cycle would lead to an exodus of assets from liquidity products have been proven wrong, says Deborah Cunningham, Chief Investment Officer for Global Liquidity Markets at Federated Hermes.

Money market funds across the industry have seen inflows of around $150 billion since the Fed cut rates in mid-September.

“Historically, in a falling-rate environment, yields of cash management products lag the direct security market,” Cunningham says. “This is because some of their holdings have locked in higher rates, and most of those won’t mature until later, at some point in the next 12 months—referred to as a laddered strategy. In contrast, some securities in the direct market, especially overnight securities and those with floating rates, trace Fed moves immediately, as does the Reverse Repurchase Facility, which now sits at 4.80%. History is only a guide, of course, but we think this will be the case as the easing continues.”