With rising inflation and interest rates dominating the financial headlines in recent weeks, I have been fielding a flurry of colleague and client questions about the likely future trajectory of US monetary policy. While I don’t claim to have all the answers, especially with so many “known unknowns” as of this writing, here are my latest thoughts.
A new policy paradigm, but inflation is a wild card
The annual US headline inflation rate, as measured by the Consumer Price Index (CPI), accelerated to 8.5% year-over-year in March 2022, its highest level since December 1981. With inflation that far above the US Federal Reserve’s (Fed’s) long-term target, I suspect the Fed will feel compelled to tighten monetary policy as swiftly as possible over the next couple of months and will likely not be as supportive of risk markets as many investors have come to expect.
To wit, in a widely anticipated policy move, the Fed on May 4 announced a 50-basis point (bp) increase in the fed funds rate, bringing its benchmark short-term interest rate from 0% – 0.50% to a target range of 0.75% – 1.00%. Meanwhile, the Fed is also intent on gradually reducing the size of its balance sheet, swollen by asset purchases made at the height of the COVID-19 pandemic, in the period ahead. A new era in US monetary policy is seemingly upon us.
What now, specifically with regard to rates and inflation? Many Fed watchers and policymakers alike have said they’d like to see the Fed achieve so-called “neutrality” over the next year, which would likely equate to a target range of around 2.5% – 3.5% for the fed funds rate by mid-2023. That would require several additional rate hikes between now and then, but of course much will depend on how the US inflation backdrop — still a source of considerable uncertainty — evolves over that time frame.
On that score, I also think there is a distinct possibility that we could emerge from this inflationary period that we are now in with a higher average inflation target than the Fed’s current 2.0% threshold. As far as I can tell, that’s not something that is being discussed much, if at all, by pundits and market participants (not yet anyway).
How much further can the Fed really tighten policy?
To no one’s surprise given the state of inflation, recent Fed rhetoric has been much more hawkish than expected last year. The US rates market has come a long way to reflect this reality, but now the all-important question is: How much policy tightening can the Fed really deliver for the rest of 2022 and into 2023, without “overtightening” and potentially tipping the US economy toward recession? Unfortunately, it’s not as easily answered as asked.
Despite many observers’ hope that the Fed can reach a neutral policy rate over the next year or so, few investors or policymakers have much conviction as to what the terminal fed funds rate should be. Again, that’s largely because of the inflation wild card: No one can be sure yet how high or how rapidly US inflation might climb before this cycle is over. What we do know is that inflation has broadened out from mainly COVID-impacted sectors last year to most areas of the US economy today. Accordingly, worker wages have risen as well, posing a real risk of a “wage-price spiral” that pushes longer-term inflation expectations even higher (Figure 1) amid ongoing global supply-chain disruptions from China’s COVID lockdowns and the Russia/Ukraine war.
Bottom line: I think it’s going to take at least two more quarters of reliable economic data to be able to calibrate with any degree of accuracy how much tighter US monetary policy will or can get from here. With that in mind, I’ll be closely tracking a variety of US financial conditions going forward, particularly key economic indicators such as: the labor market (wages and unemployment); existing home and new auto sales (both interest-rate-sensitive sectors); consumer sentiment and longer-term inflation expectations; and, of course, the realized inflation data itself. I will aim to address these topics in more detail in my next blog post.