The author is Chief Investment Officer of Franklin Templeton Fixed Income
The U.S. Federal Reserve and financial markets are conducting a long overdue reality check on inflation and interest rates. But the market is only just beginning to take into account how much the world has changed.
I believe they are still experiencing severe cognitive dissonance. Inflation has soared to its highest level since the infamous 1970s and remains high. The Federal Reserve has begun to tighten policy, policy rates have risen, and the central bank will shrink its balance sheet after ending its market-stimulating asset purchase program.
But even after signs of rising inflation in recent weeks, most investors still don’t expect rates to rise significantly or stay high for long. I think this can be very misleading.
The market expects U.S. economic growth to slow as we move into 2023 – and I agree. While real incomes still exceed pre-pandemic levels, high inflation has hurt purchasing power and will hurt household consumption. Supply chain disruptions continue to hamper production, while a combination of slightly tighter monetary policy and less generous fiscal stimulus will dampen activity.
Financial markets have grown accustomed to believing that the Fed will respond to this slowdown as it has done in the post-financial crisis era: easing monetary policy quickly and decisively. This is where I expected things to be different.
Growth is slowing this time around, and inflation is likely still too high for the Fed to stop tightening. Headline consumer price inflation has averaged 0.6% month-on-month since the start of last year. Even if that monthly rate is halved, inflation will be close to 6% year-on-year by the end of 2022 and run at an average 4.5% pace in the first quarter of 2023.
If financial markets still expect the Fed to ease policy again quickly, it is at least in part because their cognitive dissonance is backed by a large degree of wishful thinking that seems to weigh on the Fed’s own outlook.
While the policy rate remains negative after factoring in inflation, the Fed appears hopeful that inflation will fall back to its 2% target. Lowering inflation under these conditions is a feat the Fed has never succeeded in before.
How likely is it that the Fed will now achieve this goal without more decisive tightening? The Fed appears to be betting that inflation expectations will remain stable until all exogenous shocks are removed from the system. But consumers’ long-term inflation expectations are already around 4%, and wages are rising at 5.5% (the average hourly wage for all employees).
As workers, consumers and businesses learn to predict and stay ahead of the continued growth of the cost base, inflation expectations are entrenched at higher levels each month. When activity slows, it may relieve some of the pressure on this very tight labor market. But with labor force participation remaining below pre-pandemic levels, the cooling effect on wage growth is likely to be limited. Our wage price spiral is developing, which could make inflation more self-sustaining than the Fed assumes.
We operate in a very different environment than we were ten years ago. For the first time in more than 40 years, inflation has declared itself a major social and political problem. Year-on-year growth is likely to decline in the coming months as it is measured against a higher inflation base in 2021. But the effect will be slow, and we will be forever away from a supply shock of a rebound in inflation. For the past 12 years, with inflation dormant, the Fed has always been able to prioritize supporting economic growth and asset prices. This is no longer the case.
Therefore, I expect the Fed to continue raising interest rates in the first half of next year to keep inflation in check, even if growth slows. Long-term yields will also continue to move higher once the market realizes that the Fed cannot change course.
We still need to fully appreciate that inflation has become self-sustaining and that getting it back under control will be more difficult and painful than central banks hope and financial markets price in. This time around, the Fed’s tightening cycle will be longer, and policy rates and bond yields will have to be higher than the market currently expects. The corresponding risks to asset prices and economic growth are greater than many would like to admit.