In light of yesterday’s Federal Open Market Committee meeting officially beginning a cycle of monetary tightening, it seems pertinent to examine the situation the Federal Reserve (Fed) is facing in terms of inflation. In this week’s chart, I elaborate on the obstacles the Fed is facing that make this tightening cycle different from others in the era following the global financial crisis of 2007-08.
The current macroeconomic picture in the U.S. demonstrates a healthy labor market and an extremely high rate of inflation. The labor market has continued to strengthen throughout 2021 and into 2022, as employees return to work amid loosening pandemic restrictions. This is demonstrated through low unemployment and rising wages.
At the same time, as can be seen in this week’s chart, the Consumer Price Index (CPI) has been accelerating. While we have seen tightening cycles from the Fed in the years since 2008, when interest rates were first set to the zero lower bound, it is hard to view this cycle through the same lens as low inflation was sticky during those cycles. These prior cycles were more about the normalization of interest rate policy than the need to control high inflation. Today’s Fed finds itself in a completely different scenario.
It is useful to put this CPI increase in perspective. Beginning in April 2021, we saw year-over-year (YOY) CPI prints start to accelerate greatly. However, as inflation continued to tick higher, this was written off as a transitory effect due to pandemic-induced supply chain bottlenecks. Finally, in November, Fed Chair Jerome Powell removed the transitory tag and made a hawkish pivot to fight inflation. Although supply chain bottlenecks did force inflation upward, it cannot be ignored that easy credit conditions, quantitative easing and large amounts of fiscal stimulus are inflationary forces on the demand side.
While the Fed cannot control supply-side impacts, the tightening of credit conditions and runoff of its balance sheet does allow it to control demand-side forces. Given its dual mandate to keep inflation and the labor market in a healthy balance, the current macroeconomic picture makes the Fed’s hawkish pivot essential.
Continued high inflation hurts both economic growth and consumers. When consumers have to pay higher prices for goods and services, their income does not go as far as it used to. This decrease in purchasing power puts a damper on growth by harming consumption. Skyrocketing prices for energy and commodities due to the recent invasion of Ukraine have put more pressure on inflation from the supply side. The Fed has expressed that it views this primarily as an inflation shock and secondarily as a growth shock. The message from Chair Powell is clear — from the viewpoint of the Fed, high inflation is a primary focus and must be controlled.
At risk of coming off overly negative about the current landscape, it should be mentioned that there is some good news for the Fed. This week’s chart also shows the 5-year, 5-year forward breakeven inflation rate. The breakeven inflation rate is a measure of the difference in yield between nominal and inflation-linked bonds. It can be seen as the average expectation for the rate of inflation over the length of the time period. A forward rate shows the rate being implied by current market pricing for a time period in the future.
In this case, the chart is demonstrating the market expectation for the average rate of inflation over 5 years, beginning 5 years from now. It can be seen that this rate has stayed relatively flat, and roughly around 2.5%, even though YOY CPI has been running hot. This shows that expectations for future inflation have not become unanchored and the market is confident the Fed will use its tools to control the situation.
The macroeconomic situation necessitates the current hiking cycle by the Fed. Inflation has reached its highest level in over 40 years and there are signs it may continue to climb before there is a decline. Due to this high level of inflation, it is difficult to view the current cycle of tightening through the lens of past tightening cycles following the global financial crisis.
However, forward-looking inflation expectations remain anchored close to the Fed’s target level. The market is currently pricing in an additional five to six rate hikes for the remainder of 2022. In order to maintain credibility, the Fed should be willing to do what is necessary to avoid inflation becoming entrenched and the unanchoring of forward expectations, even if that means more hikes than current market pricing reflects.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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