Total Return Outlook: Encore! Encore?!

The geopolitical landscape changed dramatically in the first quarter, as news headlines shifted from the global pandemic to the war in Ukraine. Among the many consequences of Russia’s invasion, skyrocketing oil prices have triggered fears of runaway inflation, and we are now left to debate the impact on growth and inflation in the U.S. Meanwhile, we have yet to see the supply chain issues completely resolve, though we appear to be in somewhat better stead than three months ago.

The Fed has finally changed its tone and now appears to be singly focused on containing inflation. It has an unenviable task, but it is partly to blame for the current situation as its exceedingly accommodative monetary policy over the last year has left it in this very tenuous position. The question is now: Is the Fed fully committed to stopping inflation? If so, is it willing to sacrifice growth and possibly even drive the U.S. economy into recession?

In our prior outlook, we highlighted the options the Fed has in removing accommodation, and we believe these options to be more robust than the singular “inflation-killing” tone the Fed has recently adopted. To recap, these options are:

  • To counteract an overheating economy, the Fed can raise the target fed funds rate
  • To contain inflation, the Fed can reduce its balance sheet more aggressively, which would effectively raise longer maturity rates while maintaining some “dry powder” for raising shorter rates more slowly.
  • To counteract both an overheating economy and inflation, it can begin with hikes to lift the target rate off the zero bound but ultimately use both levers to affect the outcome that provides the softest landing for the economy.

Sadly, implementation of a dual-pronged quantitative tightening plan requires a level of finesse that the Fed is not known for. The Fed has taken to telegraphing its rate forecasts (“the dot plots”) as well as its open market operations in a way that makes changing course very difficult. In our opinion this policy of keeping the markets hyper-informed can be an impediment to implementing policy in the most efficient manner, but we doubt this is something that will change. If it did, imagine the market uproar – “does the Fed suddenly have something to hide?”