Where will the Fed’s fight against inflation take us?

We could be headed for a soft landing, a recession or a period of stagflation.

The Federal Reserve (Fed) is aggressively fighting inflation. Its aim is to tighten monetary policy and raise borrowing costs just enough that demand for goods falls, spending slows and prices stop rising so quickly. So far, the Fed ended its bond buying program and raised rates. In June, the Fed increased the federal funds target rate by 0.75%, which was the largest rate hike in 20 years.[1]

Geopolitical events intensify inflation worries

The Fed’s battle against inflation is complicated by geopolitical events that introduce powerful new inflationary forces. For example:

·??????The Russia-Ukraine war and subsequent sanctions are creating energy and food supply shocks. Shortages of oil, gas and grains are pushing prices higher. The World Bank forecasts that energy prices will increase by about 50% in 2022, and non-energy prices by about 19%, before moving lower again in 2023.[2]

?·??????China’s zero-COVID policy triggered the full or partial lockdown of hundreds of millions of residents in dozens of cities. Since China is responsible for about 19% of the world’s economic output, lockdowns are disrupting supply chains, making goods harder to obtain and causing prices to rise.[3]

The Consumer Price Index (CPI), which measures US inflation, showed that prices rose 8.3% year-over-year in April (although the pace of inflation slowed from the prior month). Food prices rose 9.4% in April, and energy prices were up 30.3%.[4]

Tightening monetary policy will affect the economy ?

Investors believe there is a high probability that the Fed will continue to raise rates aggressively throughout 2022,[5] which will affect economic growth. If everything goes “just right,” the Fed’s actions will slow economic growth and contain inflation without leading the country into recession.

If the Fed tightens too much, economic growth could stall out, resulting in a recession. During a recession, economic activity declines for two or more quarters. In the past, the Fed has pushed the American economy into recession to tame inflation, most notably during the late 1970s. In May, a survey of economists put the chance of recession in 2023 at 30%.[6]

Some economists are concerned about the possibility of stagflation, which is a period of slow economic growth and high inflation. The Financial Times explained the concern: “After the double shock of COVID-19 and the Russian invasion of Ukraine, inflation rates have exceeded expectations, surging to the highest levels in decades in many countries, while economic growth forecasts are rapidly deteriorating.”[7]

What does the bond market think?

While the economic outcome of the Fed’s fight against inflation remains uncertain, we can look to the bond market for clues about where the economy may be headed. When investors anticipate high inflation, typically bond rates rise and bond prices fall. This year, US Treasury yields rose through early May. After the Fed’s May meeting, the yield on benchmark 10-year Treasury notes rose above 3% for the first time in years.[8]

Since then, longer-term US Treasury rates have moved lower again. The shift suggests that bond markets, which are forward looking, are less concerned about inflation and more concerned about the possibility of recession.

While much remains uncertain about inflation and the economy, some investors may find a silver lining in higher bond yields. Today, more assets offer opportunities to invest for income with less risk, which could be particularly attractive for investors who are nearing or in retirement.

If you would like to learn more about positioning your portfolio in the current economic environment, contact me at [email protected] or 617.531.6954.

[1] Alexandra Scaggs, ‘The Fed Raised Rates the Most in 22 Years. The Market Celebrated Anyway.’ Barron’s. May 4, 2022.

[2] ‘Commodity Markets Outlook: The Impact of the War in Ukraine on Commodity Markets look’. The World Bank. April 2022.

[3] Chris Giles. ‘Is the global economy heading for recession?’ Financial Times. May 20, 2022.

[4] Consumer Price Index Summary, US Bureau of Labor Statistics. May 11, 2022.

[5] Target Rate Probabilities for 14 December 2022 Fed Meeting. CME FedWatch Tool, cited May 24, 2022.

[6] Reed Pickert. Kyungjin Yoo. ‘US Recession Odds Within the Next Year Now 30%, Survey Shows.’ Bloomberg. May 13, 2022.

[7] Valentina Romei. Alan Smith. ‘The global stagflation shock of 2022: how bad could it get?’ Financial Times. May 1, 2022.

[8] US Department of the Treasury, May 26, 2022.