Inside my head: The Fed takes the red pill

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By Sonal Desai, Ph.D., Chief Investment Officer, Franklin Templeton Fixed Income

The Fed struck a hawkish tone at its last meeting, but Sonal Desai, chief investment officer of Franklin Templeton Fixed Income, believes it still underestimates how far rates will likely need to rise, as will markets. She explains what it will take to get inflation under control and how bond investors can position themselves for the volatile rising rate environment ahead.

The Federal Reserve (Fed) has finally recognized the reality of the inflation problem. Uncertainty over the Russian-Ukrainian war didn’t stop it from raising rates at its March policy meeting, although it capped that first hike at just 25 basis points (bps). Connecting the “dots” indicates an expected total of seven rate hikes this year, and Fed Chairman Jerome Powell has indicated that quantitative tightening (reducing the Fed’s bloated balance sheet) will begin sooner than expected, likely in may.

All of this may sound rather warmongering. I had pointed out in previous writings that inflation had become a major social and political issue, and at this month’s press conference, Powell tried to channel former Fed Chairman Paul Volcker, signaling that the Fed is aggressive and determined to control inflation.

But relative to the magnitude of the inflation challenge, I think the Fed’s stance is nowhere near as hawkish as it should be, even though it looks very hawkish compared to its previous line implausibly accommodating.

In previous tightening cycles, the Fed had to raise the policy rate above inflation to bring price dynamics under control. Today, the policy rate is barely above zero, while headline consumer price index (CPI) inflation is close to 8% and the core measure of personal consumption expenditure (PCE ) preferred by the Fed is 5.2%.1 That’s a long way to go, and six more rate hikes – if that includes just one 50 basis point increase in a series of predictable 25 basis point increases – will leave the policy rate below 2% (the Federal Open Market Committee [FOMC] the median projection is 1.875%).

The Fed expects the key rate to peak at 2.75% in 2023 (FOMC median projection); only then, according to the Fed, would the policy rate rise above the core PCE, that the Fed’s plans would drop to 2.6%.

The Fed’s hawkish stance, in other words, is mostly wishful thinking. It still assumes that this inflation spurt will correct itself and that inflation will return to target even if the real interest rate remains negative throughout this year and for part of next year. also. In essence, this is not much different from the previous mantra that inflation was “transient”.

Federal funds target rate

BEA, Federal Reserve Bank of Dallas, Fed, Macrobond

Unpleasant inflation arithmetic

Here’s an update on the nasty inflation arithmetic I like to use in my inflation-themed articles: headline CPI inflation – which is what matters to consumer behavior and wage setting – averaged 0.7% month-on-month (M/M) for the last six months and 0.6% for the last 12. Let’s be optimistic and assume that it will only average 0.4% from March to December. Headline inflation should end the year at 5.6%, ie three times more than the key rate projected at the end of the year. Core PCE averaged 0.4% M/M over 2021; if it maintains this pace, it will end the year at 5%. If the headline CPI maintains the pace of the past 12 months, it will end the year near the last reading, at 7.7%. Real interest rates would remain deep in negative territory.

How can we expect inflation to behave in the coming months? Let’s take the pulse of the underlying macroeconomic situation. The U.S. labor market remains extremely tight, and cost-of-living adjustments (COLAs), where wages are automatically indexed to past inflation, are making a comeback, as inflation has consistently exceeded the forecasts of policymakers and the private sector for too long. The Fed itself expects the labor market to tighten even further, bringing the unemployment rate down to 3.5% (from 3.8% currently in February).

Geopolitical uncertainty has caused energy prices to spike, put pressure on other commodities and caused further disruptions to supply chains. (As I noted in my last “On My Mind”, the Russian-Ukrainian war also marks another setback from globalization, and the growing preference for self-sufficiency in key industries will become a major inflationary factor in long term.) Companies have discovered they have pricing power and, with rising input costs, they have no choice but to exercise it.

In other words, a number of autonomous inflationary forces were set in motion, encouraged by the continuation of an exceptionally loose monetary policy which, combined with a record increase in government spending, proved to be a major policy error. (something I believe should have been clear months ago).

To be clear, inflationary supply shocks play a role here, but they are certainly not the only ones. When a supply shock drives up inflation, a central bank must assess the risk of it triggering “second-round effects,” increases in prices and wages that will propagate and amplify the shock. It is only if this risk is significant that the central bank should react and raise rates; otherwise, he would have to wait for the supply shock to wear off. In this case, extremely loose fiscal and monetary policy had already fueled inflation since the start of the post-pandemic recovery; they are an important source of inflation on their own, and moreover, they make it inevitable that any supply shock will quickly trigger second-round effects that make its inflation spurt self-sustaining.

It is foolhardy to expect inflation to return to target on its own, even as rising prices and geopolitical uncertainty dampen economic activity.

To get inflation under control, in my view, the Fed will have to implement a much more aggressive tightening policy than it currently envisions. Achieving this will most likely require the courage to withstand significantly higher asset market volatility, which could include painful corrections. That’s when the Fed’s anti-inflation courage will be tested. If inflation remains high, its social and political costs will rise even further, and the Fed may have no choice but to get tough.

The Fed took the red pill and saw the inflationary reality we live in; but like Neo in the Matrix film, it will take longer to fully come to terms with reality and recognize what it will take to bring inflation under control.

Investment Implications

Financial investors are also facing difficult times. Markets expect a short up cycle, with fed funds peaking at around 2.75%, followed by rate cuts by 2024. Some analysts see this as a sign of an early end to economic expansion current; the flattening of the Treasury yield curve, which could invert with further rate hikes, would signal a coming recession due in part to monetary tightening. I don’t think the yield curve currently represents a reliable recession signal because there are other factors at play, especially the massive role the Fed is still playing in the market. The 10-year term premium barely budged even as inflation climbed to 8%, suggesting long-term yields are likely still capped by the Fed’s record balance sheet. Or maybe investors think the Fed will blink and ease policy again once asset prices begin a meaningful correction. In both cases, I think that the markets are still underestimating the extent of the monetary tightening to come.

How can bond investors position themselves in this difficult environment? Long-duration assets could experience a volatile and difficult period as rates climb; a shorter duration seems more attractive to us. Bond investors should also consider asset classes that are naturally aligned with rising rates, such as bank loans. We have now started to see credit spreads widen, creating some interesting pockets of opportunity in the high yield credit markets. Finally, rising commodity prices imply better prospects for commodity-rich emerging markets, and not just in energy.

What are the risks ?

All investments involve risk, including possible loss of capital. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as bond prices in an investment portfolio adjust to rising interest rates, the value of the portfolio may decline. Investments in lower rated bonds carry a higher risk of default and loss of principal. Floating rate loans and debt securities tend to be rated below investment grade. Investing in higher yielding, lower rated, variable rate loans and debt securities carries a higher risk of default, which could lead to loss of principal, a risk which may be heightened in a slowing economy. Interest earned on variable rate loans varies with changes in prevailing interest rates. Therefore, although variable rate loans offer higher interest income when interest rates rise, they will also generate less income when interest rates fall. Changes in the financial strength of a bond issuer or in the credit rating of a bond may affect its value.

1. Sources: BEA, BLS. CPI = consumer price index; PCE = Personal Consumption Expenditure

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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