All Gain, No Pain

April 7, 2022

Source:; FOMC economic projections for March 2022 meeting Source:; FOMC economic projections for March 2022 meeting

In response to the energy crisis in Europe, the International Energy Agency (IEA) published a 10-point plan last month. One point, in particular, stood out to me: For every 1 degree that Europeans turn down the thermostat in their homes, 10 billion cubic meters (bcm) of natural gas can be saved. Currently, the average household temperature is set above 71.6 degrees Fahrenheit. Europe imported 155 bcm of gas from Russia in 2021, so if people turn down the thermostat 4-5 degrees, it can save almost a third of what was imported. Few politicians have talked about measures like this that can be taken to reduce reliance on gas. Rather, many are focused on subsidizing heating bills or sourcing gas from other countries. Our current environment generally consists of politicians worrying about the next election, while some citizens aren’t particularly willing to make sacrifices even if they claim to want to do good for the planet. 

Politicians and central bankers are doing what they can to respond to the public’s demand. For example, before the pandemic, people sought jobs and now the central bank and politicians are focused on creating a high-pressure economy to maximize job creation. During the pandemic, many people needed assistance to purchase food and other goods, as a result, stimulus checks were distributed. Now that people are concerned about higher inflation and the personal impacts, our government and central bank are becoming hawkish about managing it.

Traditionally, the way to fight inflation is to raise interest rates to the restrictive area, slow down growth, drive up the unemployment rate and let the Phillips curve do the work. This process is well-known but painful.

The recent Federal Open Market Committee forecast indicated that rates would be raised to 2.8% and the Personal Consumption Expenditures inflation is expected to come down to 2.3%, while the unemployment rate would stay around the historically low level of 3.5%. Essentially, we would receive the gains of lower inflation without the pain of higher unemployment.

It’s very difficult to see how the Federal Reserve (Fed) can achieve this combination because, by forecasting lower inflation while the unemployment rate remains around 3.5%, the Fed is saying that inflation is transitory without actually using that word. Historically, the Fed would also need to hike rates 1-1.5% above the neutral rate to decrease inflation. This would mean a federal funds rate of around 3.5% to 4%, but our current market is pricing in a terminal rate of 3.1% while the Fed forecast was 2.8%. I don’t believe 3.1% is enough to bring inflation back under control.

Conversely, it is true that the inflation from goods purchases and supply chain disruptions will come down over the coming months. Last week’s ISM Manufacturing New Orders Index was at the lowest level since summer 2020. Recent auto sales, major retailer earnings reports and share prices also confirm this, although spending on services will only continue to pick up. Peter Kern, CEO of Expedia, predicts that the summer of 2022 will be the busiest travel season ever. We also saw robust growth and inflationary pressure in the ISM Services PMI Index in both the U.S. and Europe.    

Most importantly, it is the strength of the labor market that will make it much more difficult for inflation to go back to the 2.5% area. Currently, the labor market is by far the strongest it has been over the last 30 years and almost all developed countries are experiencing hiring difficulties. Current wage growth is at 5-6% of the annual rate in the U.S. and I don’t expect it to come down much over the course of 2022. If anything, the risk of a wage-price spiral is higher now, as the inflation mindset is slowly taking hold among the public and corporations.    

At some point, the Fed will have to make a choice between inflation and unemployment. To really bring down inflation, the unemployment rate will need to go higher than the natural rate of unemployment (Non-Accelerating Inflation Rate of Unemployment). The Fed believes it is 4% now, but recent research indicates it is more likely to be around 5%. Will the public accept an unemployment rate of 5% or more to rein in inflation?

Key Takeaways      

The Fed is forecasting a fairly painless path to get inflation back to its target range without a much higher unemployment rate. Given the extremely strong labor market, it is likely the Fed will need to hike much higher than 3.1%. This would drive up interest rates, especially at the front end of the curve. Higher interest rates would also likely increase volatility in the equity market.


Chart footnotes:

  1. For each period, the median is the middle projection when the projections are arranged from lowest to highest. When the number of projections is even, the median is the average of the two middle projections.
  2. The central tendency excludes the three highest and three lowest projections for each variable in each year.
  3. The range for a variable in a given year includes all participants’ projections, from lowest to highest, for that variable in that year.
  4. Longer-run projections for core PCE inflation are not collected.

Tags: Inflation | FOMC | Federal Reserve | Unemployment rate | ISM Manufacturing Index

< Go to Chart of the Week

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.

Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice.  The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete.  Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements.  Actual results may differ significantly.  Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.

Investing involves risk, including possible loss of principal.  Past performance is no guarantee of future results.  All information referenced in preparation of this material has been obtained from sources believed to be reliable, but accuracy and completeness are not guaranteed. There is no representation or warranty as to the accuracy of the information and Penn Mutual Asset Management shall have no liability for decisions based upon such information.

High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.

All trademarks are the property of their respective owners. This material may not be reproduced in whole or in part in any form, or referred to in any other publication, without express written permission.

Subscribe to Our Publications