By J. Keith Buchanan, Portfolio Manager – GLOBALT Investments
November 30th, 2021, the Federal Reserve Chairman Jerome Powell told Congress that “transitory” should be retired as a description of inflationary pressures. Since that day, Fed funds futures have gone from pricing in 59 basis points to 277 basis points of Fed tightening in this calendar year. Financial conditions have tightened, which is the intended consequence of restrictive monetary policy, and they did so months before the first actual rate hike in March.
Given the FOMC’s dual mandate of stable prices and full employment, one could reasonably accept a buoyant labor market fueled by strong economic growth as breathing room for the central bank to attack inflation before it became further entrenched. At least, this was the case just a few months ago. Today, the Federal Reserve has an even more complex dilemma on its hands. The two charts below show the manifestation of the problem itself.
Last September, just before the FOMC embarked on this journey to restrictive monetary policy, 2022 inflation expectations were 2.45% while the market expected real GDP growth at 4.3% enough cushion for a restrictive policy shift to throw cold water on inflation embers (yes, financial market media referred to inflation as “embers” back then) without recessionary or stagflationary worries seeping into the picture. However, the story has changed materially in the past eight months. Inflation expectations increased to 4.6% for 2022 while real growth expectations for the same period moved lower to 2.7%.
In fairness, there is reflexivity involved to some degree. As inflation expectations spread and interest rates move higher as a result, there is some level of crowding out that occurs at the expense of real growth. Moreover, the market is doing some of the heavy lifting for the Fed. Tightening financial conditions result in demand destruction which puts downward pressure on prices. In our opinion, the Fed’s hawkish rhetoric has possibly done more to create an environment more corrosive to inflationary pressure than the two recent rate hikes given the lagged effect of monetary policy shifts.
Nonetheless, the breathing room that the market perceived to be at the behest of the Federal Reserve last fall has all but vanished while inflation poses a larger problem than it has in a generation. We think that notion has been replaced with broad and growing skepticism of the Fed’s ability to execute the coveted soft landing and avoid a recession, and threading the proverbial needle seems more daunting by the day.
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The opinions and some comments contained herein reflect the judgment of the author, as of the date noted.
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