On My Mind – The Fed’s Last Call for the Punchbowl?

The Fed now acknowledges inflation risks are to the upside. With high uncertainty on the inflation and employment outlook, adjusting its exceptionally loose monetary stance at the right time and pace become a very difficult high-wire act. In the latest edition of our Fixed Income CIO Sonal Desai’s “On My Mind” series, she discusses the Fed’s challenge, and where she is finding opportunities in the market.

Investing is tough these days—but I’d still rather have my job than the Federal Reserve’s (Fed). The June policy meeting of the Federal Open Market Committee (FOMC) highlighted just how complex the central bank’s challenge is.1 In part it’s because the economic environment has become more complex, but in part it’s the Fed’s own fault.

The Fed’s meeting came off as more hawkish than markets expected: the median Fed funds forecasts (the “dots”) now show two interest-rate hikes in 2023 (compared to none in March); the tone on the growth and employment outlook was more upbeat; the core consumer price index (CPI) forecasts for 2021 and 2022 were raised to 3.0% and 2.1%, respectively.

But what was most striking was 1) a greater degree of humility in acknowledging the uncertainty in an outlook dominated by unprecedented shocks and policy moves; but 2) a still strong reluctance to start adjusting the policy stance.

Assessing the current inflation rebound is hard. The Fed insists it’s temporary, mostly due to base effects, and projects inflation coming down on target by next year. But this time their assessment was a bit more humble. After all, if there is something that can be foreseen is base effects—we do know the past. And yet, the May US inflation number surprised to the upside.

I do think there are more durable pressures at work here, as I argued in my LinkedIn newsletter.2 Stanford’s John Cochrane noted in a recent presentation that if you look at the price index level, you can see an acceleration that goes beyond making up for the decline of a year ago. It’s not just going back to the pre-pandemic path, it seems to be heading on to a steeper one.