The Fed, The European Central Bank (ECB) And Most Other Central Banks Have Been Talking Very Hawkishly
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Are markets correctly pricing inflation?
Sonal, it looks like the consensus view is for US inflation at about 3% year-over-year in 2023. Do you agree? What’s your view on inflation and interest rates?
Sonal: I think 3% is optimistic. A few points. First, macro policies are still pretty loose, which might sound strange when we’re looking at a US central bank that’s been raising interest rates. But the United States is looking at a fiscal deficit this year, which is probably going to be around 5% of gross domestic product (GDP). Social Security checks have gone up close to 9% this year, and those go out to about 70 million Americans—that’s about a third of the adult population.3 And, keep in mind, the Fed’s balance sheet is still huge.
Second, the market has taken a great deal of comfort from the fact that wages are moderating—as it should. Having said that, the Fed Bank of Atlanta’s latest Wage Growth Tracker showed overall wage growth of 6.1% in December, with wages up 7.7% for job switchers, and up 5.5% for people who remained in their jobs.4 And unit labor cost growth was 5.2%5.3%.5 Historically, the Personal Consumption Expenditures Index (PCE) has mapped into unit labor costs, and the December reading was far above the Fed’s 2% inflation target. So, we’re talking about US unemployment at close to 3.5%, a US fiscal deficit of around 5%, and wages still growing.
Meanwhile, markets are anticipating a Fed “pivot” in the near term, but I think some people are suffering from what I would consider a recency bias. They regard the current Fed tightening cycle as being transitory, but I would note that after the global financial crisis (GFC), the Fed spent more than 10 years fighting deflation—the dog that never barked. It threw the kitchen sink at the problem in terms of easing, because the GFC was such a terribly large and meaningful event. I think these last few years of substantially above-target inflation will probably lead us to a multiyear period where the Fed keeps rates higher than the market is currently anticipating.
To summarize, you think the federal funds rate will rise to 5% or 5.5% and that the so-called pivot toward easing won’t happen quickly. If the equity market is wrong in its current view and then sees a correction as a result, are you saying it’s unlikely the Fed will come to the rescue?
Sonal: Correct. The market believes the “Fed put” is there, but it doesn’t exist. That’s my biggest concern. Mark, let’s turn to you and Western Asset’s view. What is your outlook both for inflation and rates? Any concerns?
Mark: The forecasters on the team are talking about the possibility of US inflation at around 2% year-over-year by the end of this year. If you look at the fixing—here I am talking the near-term inflation swap6 market—if you look at the pricing on the headline Consumer Price Index (CPI), it’s somewhat surprising to many, in the fourth quarter of 2023 on a yearover-year basis, we’re 2% or below. It’s the first time in a long time the pricing or fixing on CPI is below our forecast.
Obviously, oil and energy are very important components of inflation, and oil is currently around US$75–$80 per barrel. Things could change radically. But if we do end up with year-over-year inflation declining from over 6% in 2022 down to 2% toward the end of 2023, as the market seems to be anticipating, that’s consistent with our view.
How do we get there? Certainly, the commodity side plays a part as it relates to headline inflation. But whether it’s rents, autos, medical or other services, we are seeing overall downward pressure in inflation on the goods side, on the manufacturing side. It is a bit slower on the services side. When we look at the inflation numbers and our expectations for 2023, we are optimistic that we will see a quick retracement. The worry is that the 2% inflation scenario is now priced into the marketplace; there is a disconnect between the market expectations and the Fed’s expectations. That’s where the debate gets extremely interesting.
“ When we look at the inflation numbers and our expectations for 2023, we are optimistic that we will see a quick retrace ment. The worry is that the 2% inflation scenario is now priced into the marketplace; there is a disconnect between the market expectations and the Fed’s expectations. That’s where the debate gets extremely interesting.” Mark Lindbloom
Can you elaborate a little on that disconnect and your outlook for monetary policy?
Mark: The Fed, the European Central Bank (ECB) and most other central banks have been talking very hawkishly. They are concerned that we are in an environment similar to the late 1970s and early 1980s when inflation was more buoyant and sticky than the post-GFC period, for a variety of reasons. Fed Chair Jerome Powell and other Fed officials have talked about how they’re not going to ease up the current tightening cycle quickly—essentially saying they are going to get to restrictive territory then hold rates there nearly all year. The market doesn’t believe them. The market is seeing the fed funds rate rise to 4.75% or perhaps 5%, while the Fed has been signaling 5.25%. So, the market expected—and got— a 25 bps hike at the February policy meeting, but there is anticipation of a pause—wherein the Fed can stop and assess the data. And, then assuming the economy is on a path of weakness and lower inflation, the thinking is there will be aggressive easing as we get into the latter part of 2023. At Western Asset, we are generally in line with the market for the near-term outlook, but there is an internal debate within our team regarding duration and the yield curve. We aren’t quite as sure about what happens in March. Most importantly, we think the Fed’s focus is on employment data. While a lagging indicator, earnings and wages have been very, very slow to turn. For the Fed to really shift and pause, we need to see that fall into place.
