- Fixed Income Portfolio Manager
Formats
Corporate Sustainability
Investment Solutions
Our approach to sustainability
Portugal, Institutional
ChangeThe views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
The Federal Open Market Committee (FOMC) yesterday hiked the federal funds rate by 75 basis points (bps) to a range of 3% to 3.25%, the highest level since early 2008. In his post-meeting press conference, US Federal Reserve (Fed) Chair Jerome Powell repledged the FOMC’s resolve to bring inflation down toward its 2% target, even acknowledging the central bank’s willingness to tolerate tipping the US economy into a mild recession, if necessary, to achieve that goal.
From this perspective, I see the FOMC’s strategy as one of aggressively “leaning” into inflation, to the point that tighter financial conditions could begin to choke off growth and push the unemployment rate higher. Unfortunately, I also expect inflation to prove a bit stickier than many investors anticipate, meaning the Fed may have to “leave” the financial markets with little or no support over the course of 2023 — at least until inflation falls enough to allow the Fed to start “cleaning” up the broader economy via monetary policy easing at a later date.1
The Fed’s updated Summary of Economic Projections revealed a deteriorating growth versus inflation trade-off, with below-trend growth and a modest rise in the unemployment rate. Although Fed policy-rate projections showed a notable increase from June, the FOMC apparently does not expect a sharp growth pullback in 2023.
Wages are key to getting inflation down to target
While monetary policy can do little to ease supply-chain bottlenecks or tame supply-driven inflation (core goods prices), it tends to have a much greater influence on the consumer demand side of inflation (core services prices), which is more domestically driven.
Wages are a big input into core services inflation. My leading indicators suggest wages will likely moderate in the coming quarters, giving the Fed leeway to pause its policy-tightening campaign early next year as it assesses the impact of its rate hikes — which generally work with a lag time of 12 – 18 months — on inflation and the labor market. If I’m right, the Fed could “go on hold” sooner than the market thinks. (Futures markets are currently pricing in Fed rate hikes through March 2023, up to a terminal rate of 4.5%.) The unemployment rate ended August at 3.7% and probably needs to rise above 4.5% before the Fed can gain confidence that so-called “demand destruction” will sufficiently lower inflation.
When might the Fed start paring back its balance sheet?
In Powell’s post-meeting press conference, he seemed to convey little urgency to begin selling assets from the Fed’s balance sheet, especially mortgage-backed securities (MBS), which had been a focus of market participants in the run-up to yesterday’s meeting.
One explanation: Mortgage-market activity has slowed in recent months amid the Fed’s pursuit of tighter financial conditions, enabling the central bank to prioritize interest-rate hikes as its primary policy tool in the battle against inflation. As a result, mortgage rates have increased by 300 bps since the start of the year. I also expect home prices to decline by about 10% – 20% from their peak, which should help to further reduce overall inflationary pressures.
Final thoughts for investors
As of this writing, I maintain a bias for the US Treasury yield curve to continue to flatten from here. I do not expect the Fed to make an abrupt policy shift to cutting rates next year, but rather to remain on hold for most of 2023 as it monitors the evolution of inflation and other financial conditions.
One reason I don’t see the Fed being able to ease quickly or to fully “clean” up the economy in 2023 is that I suspect inflation may end up being stickier than widely believed, judging by valuations of Treasury Inflation-Protected Securities (TIPS) these days: Their “breakeven” inflation rate of around 2.5% over the next three years simply appears too low to me.
1 The “lean versus clean” debate is usually seen as competing strategies for addressing financial imbalances, but with respect to the current inflation situation, the execution of Fed policy may necessitate a three-step process (see: Stein speech, October 2013).
Expert
Related insights
Showing
of
Insights Posts
February Fed meeting: Chair Powell strikes a more optimistic tone
Continue reading
Quick Take
2023-09-30
Spread the risk: Our top three fixed income diversifiers for 2023
Continue reading
Quick Take
2024-01-31
URL References
Related Insights
Stay up to date with the latest market insights and our point of view.
Read next
Showing
of
Insights Posts
Three themes that could define 2023 for income investors
With several macro crosscurrents at play, Portfolio Manager Peter Wilke suggests that income-oriented investors not lose sight of the “big picture” in their quest for yield.
Quick Take
2024-01-31
Peak inflation, back to goldilocks? Not so fast
Portfolio Manager Nicholas Petrucelli explains why the market could be underestimating just how complex and volatile the global economic cycle is and details the implications for inflation.
Quick Take
2024-02-29
February Fed meeting: Chair Powell strikes a more optimistic tone
The Fed just might still be able to engineer the hoped-for "soft landing" but it's not going to be easy, says Fixed Income Analyst Caroline Casavant.
Quick Take
2023-09-30
Why global investors should watch the Bank of Japan
Macro Strategist John Butler explores why global investors should watch the Bank of Japan and what is likely to happen next.
Quick Take
2024-01-31
Spread the risk: Our top three fixed income diversifiers for 2023
Fixed Income Strategist Amar Reganti highlights three types of strategies that may be well positioned to provide fixed income portfolio diversification going forward.
Quick Take
2024-01-31
CLOs: Poised to outperform in 2023?
Collateralized loan obligations (CLOs) have been sparking investor interest lately — and with good reason, say Investment Director Andrew Bayerl and Investment Specialist Celene Klimas.
Quick Take
2024-01-31
Multi-Asset Outlook — A rocky road to recovery in 2023
Markets may be jumping the gun when it comes to expectations for a policy pivot and the likely risk-asset rewards. Members of our Investment Strategy team still see bumps in the economic road, though their outlook has brightened a bit when it comes to China and other emerging markets.
Article
2024-07-31
Could Japan face a UK-style pension crisis?
Investment Director Masahiko Loo explores the risks of Japan facing a UK-style pension crisis and identifies fundamental reasons that make Japanese pension funds inherently less vulnerable.
Quick Take
2024-01-31
Take credit: Our five best credit market ideas for 2023
Fixed Income Strategist Amar Reganti highlights credit market opportunities that he expects to arise over the course of 2023, against a backdrop of slowing growth.
Quick Take
2024-01-31
Navigating the new global economy in 2023
This executive summary distills the points of view of several of our 2023 Outlook authors. Discover the risks and opportunities they see as we enter a new economic and market regime.
Article
2023-12-31
High yield: Opportunity to pivot in 2023?
Our high-yield bond portfolio managers have a guardedly optimistic outlook on the market and believe security selection will be key to benchmark-relative outperformance in 2023.
Quick Take
2024-01-31
URL References
Related Insights