- Fixed Income Portfolio Manager
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
Income: the hard worker in your portfolio deserves more credit
Continue reading
5
min
Article
2025-03-31
URL References
Related Insights
Stay up to date with the latest market insights and our point of view.
Read next
Showing
of
Insights Posts
Bonds in brief: making sense of the macro — March issue
What's driving global bond markets and what are the investment implications? Read the latest "Bonds in brief" for Wellington Investment Director Marco Giordano's monthly assessment of risks and opportunities within bond markets.
4
min
Article
2025-04-30
FOMC: Stable policy amid market volatility
The Fed is holding steady amid market turmoil. See our quick notes on the FOMC's March policy statement, forecasts, and the Fed chair's press conference.
Quick Take
2025-03-31
Is the US economy really that different since COVID?
US economists have been touting the resilience of the post-COVID economic rebound. Brij Khurana dissects several key economic indicators to see what's really changed since 2019.
Article
2025-03-31
Income: the hard worker in your portfolio deserves more credit
Income from cash is good but income from bonds is better. In a less certain macro environment, Alex King, Supriya Menon and John Mullins think the case for income only gets stronger. How can investors make the most of opportunities?
5
min
Article
2025-03-31
Bonds in brief: making sense of the macro - February issue
What's driving global bond markets and what are the investment implications? Read February's "Bonds in brief" for Wellington Investment Director Marco Giordano's monthly assessment.
Article
2025-03-31
Bonds in brief: making sense of the macro - January issue
What's driving global bond markets and what are the investment implications? Read January's "Bonds in brief" for Wellington Investment Director Marco Giordano's monthly assessment.
Article
2025-02-28
The shifting liquidity landscape: What’s at stake?
The beginning of the end could be in sight for the Federal Reserve’s quantitative tightening (QT) program. US Macro Strategist Juhi Dhawan considers the Fed's next steps and what they could mean for banks, liquidity, and markets broadly.
Quick Take
2025-01-31
Bonds in brief: making sense of the macro - December issue
What's driving global bond markets and what are the investment implications? Read "Bonds in brief" for Wellington Investment Director Marco Giordano's monthly assessment.
Article
2024-12-31
Bizarro World: Could 2024 be the opposite of 2023?
Fixed Income Portfolio Manager Brij Khurana details the dynamics that may upend investor expectations of a repeat of 2023 this year.
Quick Take
2025-01-17
Fork in the road: Slowdown or reacceleration ahead?
Markets seem to expect a much smoother ride in 2024, but are they too optimistic? Members of our Investment Strategy & Solutions Group offer their macro and market outlook, including their latest views on equities, bonds, and commodities.
Article
2026-01-31
Bonds in brief: making sense of the macro - November issue
What's driving global bond markets and what are the investment implications? Read "Bonds in brief" for Wellington Investment Director Marco Giordano's monthly assessment.
Article
2024-12-31
URL References
Related Insights