Beyond Bulls & Bears

Fixed Income

On my mind: Overdue reality check for Fed and markets has barely begun

Franklin Templeton Fixed Income Chief Investment Officer Sonal Desai believes investors’ expectations that interest rates will not rise much may be very misguided.

This article, authored by Sonal Desai, Ph.D., Chief Investment Officer, Franklin Templeton Fixed Income, was first published in the Financial Times on May 23, 2022.

The US Federal Reserve (Fed) and financial markets are experiencing a long overdue reality check on inflation and interest rates. But markets have barely begun to take into account how far the world has changed.

I believe they are still experiencing a severe case of cognitive dissonance. Inflation has surged to levels not seen since the infamous 1970s and remains stubbornly high. The Fed has started tightening, with policy rates already moving up, and the central bank set to shrink its balance sheet after ending its market-boosting asset-buying program.

But even after the evidence of inflation rises in recent weeks, most investors still expect interest rates will not rise very much and will not remain elevated for very long. I think this may be very misguided.

Markets anticipate that US economic growth will slow as we head into 2023—and here I would agree. High inflation has taken a toll on purchasing power and will hurt household consumption, even though real income still exceeds pre-pandemic levels. Supply chain disruptions continue to hamper production, and the combination of somewhat tighter monetary policy with less generous fiscal stimulus will hold back activity.

Financial markets have been conditioned to believe that the Fed will react to this slowdown in growth in the same way it always has in the post-financial crisis period: by loosening monetary policy quickly and decisively. This is where I expect things will play out differently.

This time when growth slows, inflation will in all likelihood still be too high for the Fed to stop tightening. Month-on-month headline consumer price inflation has averaged 0.6% since the start of last year. Even if that monthly pace halves, inflation will end 2022 close to 6.0%  year-over-year (Y/Y), and will be running at an average of 4.5% in the first quarter of 2023.

If financial markets are nonetheless expecting the Fed to quickly ease policy again, it’s at least in part because their cognitive dissonance has been abetted by a significant degree of wishful thinking that seems to inform the central bank’s own outlook.

The Fed seems to be hoping that inflation will fall back to its 2.0% target despite policy interest rates remaining negative after taking into account inflation. Bringing inflation down in such circumstances is a feat that the Fed has never managed before.

How likely is it that the Fed will pull that off now without a more decisive policy tightening? The Fed seems to be betting that inflation expectations will remain anchored until all exogenous shocks have been worked out of the system. But consumers’ long-term inflation expectations are already running at about 4.0% and wages are rising at a 5.5%  pace (based on average hourly earnings of all employees).

Every month that goes by, inflation expectations become entrenched at a higher level as workers, consumers and businesses learn to anticipate and get ahead of persistent increases in their cost base. When activity slows, it could take some pressure off this very tight labor market. But with labor force participation persistently below pre-pandemic levels, the cooling impact on wage growth might be limited. We have a wage-price spiral developing that will probably make inflation more self-sustaining than the Fed assumes.

We operate in a very different environment than we did a decade ago. Inflation has asserted itself as a major social and political issue for the first time in more than 40 years. The Y/Y rate may abate in coming months because it is measured against the higher base of inflation as 2021 progressed. But the effect will be slow and we will always be one supply shock away from inflation bumping back up. During the past 12 years, the Fed could always afford to give priority to supporting economic growth and asset prices because inflation remained blissfully dormant. This is no longer the case.

I, therefore expect that even as growth slows, the Fed will keep hiking rates during the first half of next year, in order to bring inflation back under control. And that once markets realize the Fed cannot afford to reverse course, long-term yields will also move higher still.

We still need to acknowledge fully that inflation has become self-sustaining, and bringing it back under control will be harder and more painful than the central bank hopes and financial markets are pricing in. 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.

What are the risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline.

Important legal information

This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. This material may not be reproduced, distributed or published without prior written permission from Franklin Templeton.

The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The underlying assumptions and these views are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. There is no assurance that any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets will be realized. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. Past performance is not necessarily indicative nor a guarantee of future performance. All investments involve risks, including possible loss of principal.

Any research and analysis contained in this material has been procured by Franklin Templeton for its own purposes and may be acted upon in that connection and, as such, is provided to you incidentally. Data from third party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data.  Although information has been obtained from sources that Franklin Templeton believes to be reliable, no guarantee can be given as to its accuracy and such information may be incomplete or condensed and may be subject to change at any time without notice. The mention of any individual securities should neither constitute nor be construed as a recommendation to purchase, hold or sell any securities, and the information provided regarding such individual securities (if any) is not a sufficient basis upon which to make an investment decision. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.

Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and/or their distributors as local laws and regulation permits. Please consult your own financial professional or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.

Issued in the U.S. by Franklin Distributors, LLC, One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com – Franklin Distributors, LLC, member FINRA/SIPC, is the principal distributor of Franklin Templeton U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.

CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.

Get Content Alerts in My Inbox

Receive email alerts when a new blog is posted.