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

Jason England

Published: 10:00pm, 31 Jul, 2022

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The US Federal Reserve, which last week raised its benchmark overnight lending rate further by 0.75 percentage point, has a new challenge: figuring out how to reconcile uncomfortably high inflation with incipient signs of a slowing economy.

Having misdiagnosed the malady of persistent – and accelerating – inflation last year, Fed officials are unlikely to take their eye off the ball until there is clear and convincing evidence that price rises are moderating.

With headline inflation above 9 per cent, we are not there yet. So despite having increased the rate by 2.25 percentage points this year, US monetary policy is unlikely to have reached peak hawkishness.

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.

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US Federal Reserve authorises another big rate hike in bid to curb inflation

The past three rate decisions were slam dunks. Consumption was strong as the economy emerged from the pandemic and household finances were buoyed by government programmes. By many measures, the US economy remains healthy.

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.

Other data shows that higher rates, along with other tightening measures, may be starting to bite. Monetary policy tends to have a lagged effect and while it’s only four months since the Fed began raising rates and reducing its balance sheet, the cycle has taken on a truncated nature. Given the speed of recovery and degree to which demand – and inflation – overheated, the dampening effects of tighter policy may arrive sooner than anticipated.

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.

Bond prices have been working overtime to reflect investors’ expectations of policy rates, manifesting in the changing shape of the Treasuries yield curve. Plummeting yields on longer-dated bonds show the market taking the Fed’s word that it will not take its foot off the pedal until inflation recedes towards its preferred 2 per cent target.

This is likely to play out, and in contrast to only a few months ago, longer-dated Treasuries may prove less volatile over the near to mid-term, with the 10-year yield likely to be capped at 3 per cent.

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