Can the Fed engineer a soft landing?

Jeremy Forster, Fixed Income Portfolio Manager

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As widely expected, the Federal Open Market Committee (FOMC) yesterday raised its target federal funds rate (for the first time since 2018!) by 25 basis points (bps) and hinted that it will likely begin to reduce the size of its balance sheet “at a coming [Fed] meeting.”

Clearly, the recent tightening of global financial conditions since Russia’s invasion of Ukraine has not yet deterred the Federal Reserve (Fed) from sticking to its well-telegraphed intention to gradually remove monetary policy accommodation in response to persistent US inflationary pressures. The Fed also boosted its inflation forecasts, lowered its economic growth forecast, and now projects seven total rate hikes this year (up from three projected hikes as of January).

Geopolitical events could influence monetary policy

I expect the Fed to more or less “look through” the recent volatility of commodity prices (especially oil), unless soaring prices exacerbate a cost-push-driven growth slowdown.

In my view, compared to Europe, the US should be relatively shielded from today’s new, highly uncertain geopolitical landscape, given its greater domestic oil production and its lesser reliance on oil imports from Russia. Nevertheless, the Fed is likely to remain keenly cognizant of the risk of tightening policy too aggressively against a backdrop of elevated geopolitical tensions, which should further contribute to the “stickiness” of inflation. The potential heightened volatility of the global financial markets underscores why the Fed typically prefers to hike rates slowly and methodically.

Stagflation risks appear to be on the rise

The anticipated economic growth slowdown in an environment of stubbornly high inflation has raised the troubling specter of 1970s-style “stagflation.” While not my base case as of this writing, stagflation risks have indeed increased and should not be summarily dismissed, particularly if ongoing global supply-chain disruptions deteriorate, or if consumer inflation expectations fail to come down as policy rates rise and the economy slows.

The Fed faces a legitimate challenge in trying to engineer a soft landing as the US economy transitions from post-COVID recovery “boom” mode to a more normalized trend growth rate. The labor market is another aspect to this challenge: The Fed’s updated Summary of Economic Projections indicates an expected US unemployment rate range of 3.2% – 3.7% through 2024, which seems overly optimistic to me given the policy tightening that will likely be necessary to bring down inflation.

The recent spike in oil prices following the Russian invasion may tempt drawing parallels with the stagflationary episodes of the 1970s and 1980s, each of which coincided with dramatically tighter US monetary policy. But given the long and variable lags in inflation data, we will need to monitor trends of broader inflation measures (shelter, core goods and services, etc.) before assigning a higher probability to stagflation in the quarters ahead.

When might the Fed start paring back its balance sheet?

In Fed Chair Jerome Powell’s post-meeting press conference yesterday, he suggested that the Fed might begin winding down its balance sheet in the coming months.

I expect a cap of roughly US$100 billion per month on asset sales, broken down between US$70 billion in US Treasuries and US$30 billion of agency mortgage-backed securities. While we do not yet know the ultimate size the Fed’s balance sheet will need to be in order to maintain the fed funds rate within its target range and to manage bank liquidity demands, my estimate is that the balance sheet will be trimmed by US$2.5 – US$3.5 trillion in the years ahead.

Final thoughts for investors

I remain concerned that today’s geopolitical risks may last longer than many market participants expect, potentially prompting the Fed to take a more cautious, measured approach to tightening monetary policy. Acknowledging that the outcomes of geopolitical events are difficult at best to handicap, I think the risks are skewed toward a prolonged conflict that could end up involving more nations than just Russia and Ukraine. From where I sit, a lot needs to “go right” (and it may not) for the Fed to deliver on its expectation of hiking interest rates at every meeting this year.

Authored by
jeremy forster
Jeremy Forster
Fixed Income Portfolio Manager



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