On My Mind: The Fed Takes the Red Pill

The Fed struck a hawkish tone at its latest meeting, but Franklin Templeton Fixed Income Chief Investment Officer Sonal Desai believes it still underestimates how far rates will likely need to rise—and so do the markets. She discusses what it will take to get inflation back under control, and how fixed income investors can position for the volatile rising-rate environment ahead.

The Federal Reserve (Fed) has finally acknowledged the reality of the inflation problem. The uncertainty raised by the Russia-Ukraine war did not stop it from raising rates at its March policy meeting, though it capped this first hike to just 25 basis points (bps). Connecting the “dots” points to an expected total of seven rate hikes this year, and Fed Chair Jerome Powell indicated that quantitative tightening (shrinking the Fed’s bloated balance sheet) will start sooner than expected, likely in May.

This might all sound rather hawkish. I had stressed in previous writings that inflation had become a major social and political problem, and in this month’s press conference, Powell tried to channel former Fed Chair Paul Volcker, signaling the Fed is aggressive and determined to bring inflation under control.

But compared to the magnitude of the inflation challenge, I believe the Fed’s stance is nowhere near as hawkish as it should be—though it sounds very hawkish compared to its previous implausibly accommodative line.

In previous tightening cycles, the Fed has had to lift the policy rate above inflation to bring price dynamics back under control. Today, the policy rate is barely above zero while headline Consumer Price Index (CPI) inflation is close to 8% and the Fed’s preferred core Personal Consumption Expenditures (PCE) measure stands at 5.2%.1 That’s a long way to go, and another six rate hikes—if this includes just one 50 bps bump in a series of predictable 25 bps increments—will leave the policy rate under 2% (the Federal Open Market Committee [FOMC] median projection is 1.875%).