FIXED INCOME, inflation and US monetary policy

We’ll soon reach peak hawk – if we haven’t already. That’s to say, the world’s most important central bank, the US Federal Reserve, is close to its most aggressive in the current inflationary cycle. Not only will price pressures begin to ease over the coming months, but a recent spike in bond yields shows that the Fed’s hawkish rhetoric has already done some of its heavy lifting.

That the Fed hiked interest rates at its May policy meeting by 50 basis points and flagged further similar moves in the meetings that follow merely confirms what the market had been anticipating. But there are reasons to believe that investors' most pessimistic expectations about policy tightening won't come to pass.

We expect inflation to roll over during the second quarter, peaking at 8.6 per cent in the US (see Fig. 1). US inflation has been running hotter than elsewhere in the developed world because of the country’s aggressive policy responses to the Covid pandemic, not least huge infusions of fiscal stimulus. But the fiscal taps are closing and the Fed has started to unwind its exceptionally easy policy. At the same time, some of the supply constraints that have caused a surge in commodity and other input prices are starting to ease. And though the Ukraine conflict could yet drive another spike in energy and raw materials prices, they are unlikely to revisit earlier highs due to slowing global growth and as emergency stockpiling tapers off.

Fig. 1 - Peaky

US CPI and forecasts, % change year on year

Oil prices have been a major driver of rising price pressures. But their decline from highs is already filtering through to headline inflation. If oil prices stay at current levels – some USD107 from a peak just under USD140 – this will already prove disinflationary on a headline basis. So, subject to the caveat that Western sanctions against Russia cause an even bigger drop off in Russian energy supplies, energy prices should be less of an inflationary force over the coming quarters.

Core inflation – which strips out volatile food and energy prices – will meanwhile moderate on the back of base effects. Goods prices have already peaked, with those for durable goods dropping back and input prices falling. The latest purchasing manager surveys show that delivery times have started to shorten which highlights that supply bottlenecks are starting to open. And it seems that core personal consumption expenditure, the Fed’s preferred inflation measure, has peaked already. It was down to 5.2 per cent year-on-year in March from 5.3 per cent in February on declines in Covid-sensitive items and durable goods. 

Meanwhile, the market's anticipation of US interest rate rises has led to a tightening of financing conditions: 30-year US Treasuries have lost a third of their value from their peak in response to expectations of Fed tightening. This has fed through to mortgage rates – the average 30-year fixed rate mortgage rate has risen some 220 basis points over the past year to nearly 5.4 per cent. This has had a chilling effect on mortgage demand, with both loan applications and refinancing dropping sharply.

Fig. 2 - Long-term anchored

University of Michigan inflation expectations 1 and 2-5 years, % year on year

Given the importance of housing to the US economy, the Fed will have taken note. It is less likely to take comfort in first quarter GDP, however, even though on advance indicators fell 1.4 per cent on an annualised basis against expectations of a 1.1 per cent rise – the first fall since the pandemic. That’s because domestic demand was up to 3 per cent annualised from 2 per cent annualised in the previous quarter – and domestic demand is what matters to the Fed in setting monetary policy. Yet risks to growth are certainly building and further weakness in the data is likely to make the Fed pivot again, as it did away from the “transitory inflation” view when it saw inflation really wasn’t going away anytime soon.

Above all, the Fed is likely to take encouragement from the fact that inflation expectations remain well anchored. Although surveys show that inflation expectations for next year have jumped, reflecting the current state of price rises, those for two and five years hence are well anchored at only a little above the Fed’s 2 per cent target (see Fig. 2). This is in sharp contrast with the state of expectations during the late 1970s – a repeat of which represents the Fed’s nightmare scenario. Then, inflation expectations were consistently high across time horizons.

Perhaps one of the strongest signs that the Fed has reached ‘peak hawk’ was when arch dove San Francisco Fed President Mary Daly raised the prospect that the central bank’s next move could be a 75 basis point hike in an effort to speedily return overnight borrowing rates to around 2.5 per cent. That’s broadly accepted as the likely neutral rate for the US economy, which it to say it is neither stimulative nor contractionary.

Daly has been among the Fed’s most vocal doves and to have her talk about a 75 basis point hike – even if she doesn’t advocate it – suggests a hawkish consensus at the central bank. This capitulation by the doves is another reason to suppose the Fed is getting closer to peak hawk. Fed chair Jerome Powell made it clear that the board was not actively considering a move of this magnitude in comments following the May rate hike, which went some way to soothe the markets. If, indeed, the central bank has reached peak hawk, short-dated bonds start to look attractive, and investors should be looking for a recovery in US bonds, emerging market debt and investment grade credit in particular.

Inflation has become a significant political issue. Given the Fed board’s solidifying consensus around taking an aggressive anti-inflationary stance, any evidence suggesting inflation really is transitory is likely to mark both a high point in the central bank’s hawkishness and signal that tightening will soon come to an end.

PictetAM chief strategist Luca Paolini contributed to this article.