A less hawkish tone than expected from the Fed last week should fool no one. Inflation appears increasingly persistent, and investors may fully embrace the reflationary narrative. This means that currently undervalued bond yields could rise as the Federal Reserve’s normalization ambitions continue to fade.

If inflation persists, the Fed’s potential shift in discourse and trajectory could significantly impact the future of the money market. The central bank’s initial assumption of transitory inflation may prove to be a miscalculation.

Progress on inflation is slowing, and growth remains robust. Core PCE, the Fed’s preferred price gauge, has hovered between 2.8% and 2.9% over the past four months. This reinforces the idea that economic changes have structurally increased cost pressures. According to the ISM survey on factories, the most recent inflation data available, 13 out of 18 industrial sectors reported paying higher prices. We have producer prices still above pre-pandemic levels, sales exceeding expectations in 2024, with strong operational production and a supply chain supporting increased activity. In the S&P Global PMI report, the rate of price increases remained well above the average observed over the decade preceding the pandemic, with companies still able to pass on higher commodity prices to customers.

Investors are beginning to believe that inflation measures will stabilize between 2.5% and 3%, over the 2% FED official target. Another explanation arises: monetary policy may not be as tight. In other words, the neutral interest rate adjusted for inflation, the level that neither stimulates nor restrains growth, is higher than the Fed officials’ estimate. This would mean that the current federal funds rate is less restrictive for growth. The argument finds justification in significant budget deficits and public investments for a decarbonized economy. Added to this is the end of Globalization, which was a deflationary phenomenon. The rise of protectionism and the emergence of regionalization in the global economy adds further weight to this explanation. These factors, some of which are structural, have pushed up the neutral interest rate. If this is the case, the Fed should keep rates higher for longer, even raise them to seek a neutral rate for the economy.

If this is the case, bond yields will need to adjust upwards. Short positions on the SOFR will likely increase as higher and longer rates are factored in. Likely, money market funds will remain popular among investors.