Completed October 17, 2022. By Audrey Bismuth, Global Macro Researcher, La Française AM
The U.S. September inflation report was disappointing despite aggressive action taken by the Federal Reserve System (Fed) since March, i.e., hiking rates by 300 basis points (bps) from near zero to a target range of 3% to 3.25%. Overall, consumer pricing was above expectations, increasing 0.4% month on month (MoM), while core prices, which exclude food and energy, increased by 0.6%, also above consensus. Annual inflation eased slightly from 8.3% in August to 8.2% in September, while underlying inflation accelerated from 6.3% to 6.6%, the highest reading in 40 years.
As long as inflation risk persists, the Fed will continue to adopt an aggressive stance. We believe it is premature to entertain discussions regarding a change to monetary policy. Inflation is too high and the labor market is too tight. Since the July committee, Fed policymakers are weary of sending what could be perceived by the market as a dovish message. The Fed is pushing back expectation regarding rate cuts. Currently, investors expect the central bank to loosen monetary policy in Q4 of 2023 by dropping rates by 40 bps. Markets are betting on a soft-landing.
The Fed wants to avoid inflation expectations becoming unanchored because expectations impact wage negotiations and fuel the ‘wage-price spiral’. Highly sensitive to gasoline prices, consumer inflation expectations rose in October for the first time since March. The University of Michigan's preliminary survey showed that one-year inflation expectations rose to 5.1% in October, up from 4.7% in September.
Macroeconomic indicators are showing the first signs of progress following Fed monetary policy tightening. However, the effects of rate hikes can take up to 12 months to be felt in the real economy. As Fed Vice Chair Lael Brainard indicated recently “the moderation in demand due to monetary policy tightening is only partly realized so far”. In the housing market for example, home sales have fallen as mortgage rates have climbed to a 16-year high of 6.9%. In the labor market, the number of job openings declined by more than one million in August to just under 10.1 million. Wage growth has also slowed; the Atlanta Fed Wage Growth Tracker, which is a measure of the nominal wage growth of people, was at 6.3% in September after 6.7% in August.
Nevertheless, these figures are still high by historical standards. In addition, the latest US inflation surprise and solid employment data raise questions about the Fed’s interest rate hikes.
- Firstly, could economic data push the Fed to take rates higher, causing more pain on the U.S. economy and foreign markets given the strength of the dollar? It is likely. According to the September “dot plot”, six of the Fed’s nineteen policymakers signaled 5% next year for their upper target boundary while the median range projection was at 4.75%. If the Fed increases rates by another 75 bps in December, markets could anticipate a terminal rate above 5%.
- Secondly, could more rate hikes resolve inflation which is currently driven by supply shocks, rising energy costs and corporate margins? Probably not. As Fed Vice Chair Lael Brainard underlined recently: “The return of retail margins to more normal levels could meaningfully help reduce inflationary pressures in some consumer goods, considering that gross retail margins are about 30 percent of total sales dollars overall”. Additionally, the U.S central bank needs to significantly shrink its balance sheet to reduce inflation.
- Thirdly, could a central bank act alone in the fight against inflation, i.e., without government support? The answer is no. Look for example at the UK’s attempt to boost its economy with fiscal stimulus which backfired and triggered a bond sell off this month. Fiscal and monetary policy need to converge towards less stimulus in order to win the battle against inflation.
Until the Fed ends its tightening cycle, which according to market anticipations will not happen before March 2023 at best, the rise in real yields will continue to weigh on risky assets and bonds. A slowdown in the pace of monetary tightening will offer but temporary relief for most asset classes. Given the real risk of a recession, we believe that investors will search mainly for duration.