Signs of US economic slowdown complicate Federal Reserve’s inflation battle
- The US central bank is bent on taming inflation but with core price rises slowing, consumption dropping and jobless claims growing, it may find itself having to address recession concerns
- While longer-dated Treasuries may prove less volatile over the near to mid-term, the path of shorter-dated yields is less certain
The past year has amply shown that the Fed’s objectives of providing guidance and being data-dependent can be incompatible. In December last year, it estimated its policy interest rate would end 2022 at 0.875 per cent – this has since crested 2.50 per cent. Data won out.
If the rhetoric shift is any indication, Fed officials have learned their lesson and now place greater emphasis on data over maintaining a path preordained by guidance. In addition to keeping policy calibrated, the ascendancy of data should help the Fed repair its damaged credibility.
That said, the Fed could move in an orderly fashion and avoid overreacting to any data point. The US economy is complex and there can be considerable noise in higher-frequency data.
But consumption has slowed from its post-lockdown peak and the willingness of consumers, a major economic driver, to put up with higher prices – and financing costs – bears close monitoring.
Evidence is emerging. Core inflation fell from the March peak of 6.5 per cent to 5.9 per cent last month, and headline inflation may follow. The labour market is losing steam as the four-week average of initial weekly jobless claims rose from April’s low of about 170,000 to over 240,000 this month. This still indicates a healthy labour market, but given how jobs are used to calibrate the economy to changing conditions, this figure merits further observation.
The path of shorter-dated yields over the next few months may be less certain. Eager to regain credibility, the Fed won’t stop tightening until inflation is defeated and is likely to front-load rate increases. Futures movements suggest investors see policy rates reaching 3.5 per cent in December – the equivalent of four more 0.25 percentage point increases.
But even this rate could be reached sooner rather than later – a view at odds with current market pricing – to allow tightening conditions to take full effect before the Fed decides how to proceed.
With the market giving credence to the Fed’s ability to reel in inflation, investors should reconsider exposure to more rate-sensitive bonds. These securities were punished earlier in the year as investors thought the Fed would be behind the curve on inflation. Since the pandemic, yields have reset at levels that offer higher income streams and greater diversification.
September’s Fed conclave could be considerably more impactful. The Fed will have more weeks of data to decipher and it will be worth monitoring whether additional signs of an economic slowdown shift the balancing act from its preference for taming inflation towards possibly growing concerns of igniting a labour market recession.
Jason England is global bonds portfolio manager at Janus Henderson Investors