It has taken four decades, but the Federal Reserve has finally shaken off its fear of inflation. The markets are only just waking up to the implications of the shift.The outlines of the turnaround have been developing for a while as the Feds focus has moved from its inflation mandate to a constant emphasis on its goal of full employment. Meanwhile, its measure of rising prices has moved to an average target, allowing inflation to overshoot a 2% goal to make up for past misses. Markets

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Last week, Fed Chairman Jerome Powell underlined the final two steps: looking at where inflation actually is, rather than worrying about where it is forecast to be, and making clear that neither the current wild excess in the stock market nor the recent run-up in bond yields bothers him.

The shift should prompt a re-evaluation of the dominant market narrative. Up to now, the assumption has been that the Fed will tolerate some short-term inflation created by President

Joe Bidens

$1.9 trillion stimulus, but that in the long run the Fed will reassert control or inflation will go away by itself.

In the bond market, this version of the story shows up in heightened inflation expectations for the next five yearsa break-even rate of 2.51%, albeit on a measure that typically comes in higher than the Feds preferred gauge of inflation. For the following five years, inflation expectations are much lower, just 2.11% on Friday; if right, it would almost certainly mean the Feds preferred inflation measure would be below its 2% target.

An alternative narrative is far more political, and has been growing in popularity with investors who look at economic history. It starts with the transformation of the deficit debate. After the Obama stimulus of 2009 even Democrats were concerned about how it would be paid for, and the popular parallel was to troubled states such as Greece.

This time round the mainstream Democrat concern, such as it is, is that spending too much might prompt inflation.

Sure, Congressional Republicans have rediscovered fiscal probity since losing the White House, and the Democrats majority couldnt be more fragile. But in the past decade virtually everyone has come to understand the core tenet of modern monetary theory, that the issuer of dollars isnt going bust.

Here the story moves to the Fed. A hawkish Fed can counteract a big-spending White House by hiking rates. But Mr. Powell has committed to no hikes until inflation is sustainably at the Feds target and the country is at full employment. Most policy makers think that means at least three more years of near-zero rates.

The question is what happens if the target is reached earlier. If inflation picks up fast, say to 3%, will the Fed be willing to hike rates early and risk a rise in unemployment? What about 4%?

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Fed policy makers have been emphasizing that reaching full employment helps the marginalized in society the most. The flip side is that pushing up unemployment to restrict inflation will hit that group the most. Politically that makes tighter monetary policy harder to justify.

There are also broader issues pushing toward higher inflation, as

Pascal Blanqué,

chief investment officer at French fund manager Amundi Asset Management points out. Rising national rivalry, as well as export restrictions on protective equipment and vaccines, encourages companies and governments toward secure domestic supply chains, even if that leads to higher costs.

A synchronized global recovery this year will mean upward pressure on commodity prices, a classic source of inflation. And Covid-related disruption has led to widespread production problems, including shortages of shipping containers and critical parts for cars, which again points to higher prices.

Theres an ongoing shift from the narrative of secular stagnation to what I call the road back to the 1970s, Mr. Blanqué says.

I think it is safe to leave the flowery bell-bottoms in the closet. Serious inflation is still very unlikely, albeit now more likely than it was. The jobs market is much more flexible than in the 1970s, making wage-price spirals difficult, while there is still plenty of international competition to restrict the ability of companies to jack up prices. These trends might reverse, but it will take years for unions to build their power and economies to be reoriented to domestic production.

However, everything is in place for at least a bout of market anxiety about inflation.

Inflation is poised to leap higher in the next few months due to a sharp dip in prices a year ago, as Mr. Powell himself pointed out on Wednesday. He said the Fed would ignore what he expected to be merely a blip. The economy is likely to be growing fast, too; the New York Feds Nowcast model, for example, predicts 6.3% annualized growth in the first quarter.

Combine that with a commitment to low rates and a president already moving on to his next spending plan, and it makes sense that people would worry more about rising prices.

Investors are primed for an inflation scare, says

Dario Perkins,

an economist at strategists TS Lombard, even though he thinks it is unlikely to last.

The obvious bets to profit from an inflation scare are the reverse of what worked last year: dump Treasurys, dump high-grade bonds, dump growth stocks, buy cheap economically-sensitive cyclical stocks, buy commodities, buy junk bonds.

Federal Reserve Chairman Jerome Powell tells WSJs Nick Timiraos there is no plan to raise interest rates until labor-market conditions are consistent with maximum employment and inflation is sustainably at 2%. Photo: Eric Baradat/Agence France-Presse/Getty Images.

The market overall might rise or fall, depending on its constituents, as last Thursday showed: The S&P 500 was dragged down by big falls in growth stocks, even as its cheap and cyclical members suffered less and banks rose. In Europe, the same pattern led to a rise in the market, as cheap and cyclical stocks make up a bigger share.

A lot of this has already happened, as the same trades benefit from economic reopening. So the scare will have to be big to overcome whats already anticipated in the price.

Yet, a permanent regime shift clearly isnt priced into Treasurys. Even after last weeks jump, the 10-year still only yields around 1.7%, and long-term bond market inflation expectations have been stable. Investors, in the main, accept Mr. Powells pitch, and think that after a brief period of higher price rises, the Fed will be willing to assert its independence and keep inflation in line.

If the market loses confidence, long-dated Treasury yields should ramp up even faster, the dollar would slide and stocks most reliant on profits far in the future, think Tesla, will be hit hard.

Real inflation scares hurt.

Write to James Mackintosh at [email protected]

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