The author is Chief Investment Officer at Franklin Templeton Fixed Income
The US Federal Reserve and financial markets have a long history of experiencing inflation and interest rate reality checks. But the markets are only just beginning to take into account how much the world has changed.
I believe they are still experiencing a severe case of cognitive dissonance. Inflation has reached levels not seen since the infamous 1970s and remains stubbornly high. The Fed has started to tighten, with policy rates already rising and the central bank set to shrink its balance sheet after ending its asset purchase program aimed at stimulating the market.
But even after signs of rising inflation in recent weeks, most investors still expect interest rates to not rise much or stay high for very long. I think that may be very misguided.
Markets expect US economic growth to slow as we approach 2023 – and here, I agree. High inflation has weighed on purchasing power and will weigh on household consumption, although real income is still above pre-pandemic levels. Supply chain disruptions continue to hamper production, and the combination of somewhat tighter monetary policy with less generous fiscal stimulus will dampen activity.
Financial markets have been conditioned to believe that the Fed will respond to this slowdown in growth the same way it has always done in the post-financial crisis era: by easing monetary policy quickly and decisively. This is where I expect things to play out differently.
This time around, when growth slows, inflation will in all likelihood still be too high for the Fed to stop tightening. Headline month-to-month consumer price inflation has averaged 0.6% since the start of last year. Even if that monthly pace halves, inflation will end 2022 at nearly 6% year-over-year and hold steady at an average of 4.5% in the first quarter of 2023.
If financial markets nonetheless expect the Fed to ease policy soon, it’s at least partly because their cognitive dissonance has been encouraged by a significant degree of wishful thinking that appears to illuminate the central bank’s own outlook. .
The Fed seems to be hoping that inflation will return to its 2% target despite key interest rates remaining negative after taking inflation into account. Bringing inflation down under such circumstances is a feat the Fed has never managed before.
How likely is the Fed to get there now without more decisive policy tightening? The Fed seems to be betting that inflation expectations will remain anchored until all exogenous shocks have been eliminated from the system. But consumers’ long-term inflation expectations are already hovering around 4% and wages are rising at a rate of 5.5% (average hourly wage of all employees).
With each passing month, inflation expectations become entrenched higher as workers, consumers and businesses learn to anticipate and stay ahead of persistent increases in their cost base. When activity slows, this could ease the pressure on this very tight labor market. But with labor force participation consistently below pre-pandemic levels, the chilling effect on wage growth may be limited. A wage-price spiral is developing that will likely make inflation more self-sustaining than the Fed assumes.
We operate in a very different environment than ten years ago. Inflation has emerged as a major social and political problem for the first time in over 40 years. The year-over-year rate could decline in the coming months as it is measured against the higher inflation base as 2021 progressed. But the effect will be slow and we will always be one supply shock away from a rise in inflation. Over the past 12 years, the Fed has always been able to afford to prioritize supporting economic growth and asset prices, as inflation has remained perfectly asleep. This is no longer the case.
So I expect that, even if growth slows, the Fed will continue to raise rates in the first half of next year, to bring inflation under control. And that once markets realize the Fed can’t afford to reverse course, long-term yields will also rise further.
We have yet to fully recognize that inflation has become self-perpetuating and that it will be harder and more painful to bring it under control than central banks and financial markets anticipate. This time, the Fed’s tightening cycle will be longer and policy rates and bond yields will have to go higher than markets currently expect. The corresponding risk to asset prices and economic growth is greater than many like to admit.