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The Fed’s “lean, leave, then clean” strategy

Jeremy Forster, Fixed Income Portfolio Manager
2022-12-31
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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).

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