Timely musings on Fed policy and inflation

Jeremy Forster, Fixed Income Portfolio Manager
Archived info
Archived pieces remain available on the site. Please consider the publish date while reading these older pieces.

The 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.

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.

Figure 1
timely musings on fed policy and inflation fig1


Related insights

Read next


Past results are not necessarily indicative of future results and an investment can lose value. Funds returns are shown net of fees.
Source: Wellington Management

© 2022 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. The Overall Morningstar Rating for a fund is derived from a weighted average of the three, five, and ten year (if applicable) ratings, based on risk-adjusted return. Past performance is no guarantee of future results.

The content within this page is issued by Wellington Management Singapore Pte Ltd (UEN: 201415544E) (WMS). This advertisement or publication has not been reviewed by the Monetary Authority of Singapore. Information contained on this website is provided for information purposes and does not constitute financial advice or recommendation in any security including but not limited to, share in the funds and is prepared without regard to the specific objectives, financial situation or needs of any particular person.

Investment in the funds described on this website carries a substantial degree of risk and places an investor’s capital at risk.  The price and value of investments is not guaranteed and may fall or rise. An investor may not get back the original amount invested and an investor may lose all of their investment. Investment in the funds described on this website is not suitable for all investors. Investors should read the prospectus and the Product Highlights Sheet of the respective fund and seek financial advice before deciding whether to purchase shares in any fund. Past performance or any economic trends or forecast, are not necessarily indicative of future performance. Some of the funds described on this website may use or invest in financial derivative instruments for portfolio management and hedging purposes. Investments in the funds are subject to investment risks, including the possible loss of the principal amount invested. None of the funds listed on this website guarantees distributions and distributions may fluctuate and may be paid out of capital. Past distributions are not necessarily indicative of future trends, which may be lower. Please note that payment of distributions out of capital effectively amounts to a return or withdrawal of the principal amount invested or of net capital gains attributable to that principal amount. Actual distribution of income, net capital gains and/or capital will be at the manager’s absolute discretion. Payments on dividends may result in a reduction of NAV per share of the funds. The preceding paragraph is only applicable if the fund intends to pay dividends/ distributions.  Performance with preliminary charge (sales charge) is calculated on a NAV to NAV basis, net of 5% preliminary charge (initial sales charge). Unless stated otherwise data is as at previous month end.

Subscriptions may only be made on the basis of the latest prospectus and Product Highlights Sheet, and they can be obtained from WMS or fund distributors upon request.

This material may not be reproduced or distributed, in whole or in part, without the express written consent of Wellington Management.