It’s Like Déjà Vu All Over Again … Again

The Fed remains singularly focused on containing inflation but has made little headway so far. We anticipate the tightening cycle will continue, which will keep downward pressure on risk assets.

It’s Like Déjà Vu All Over Again … Again

Indeed, the more things change, the more they stay the same. As we wrote last quarter, the Fed continues to be singularly focused on containing inflation but has made little headway so far, despite two 75 basis point hikes in the fed funds rate. We suspected it might take time for tightening monetary policy to filter its way through the economy, and in this regard we have not been disappointed. Financial markets, on the other hand, have reacted much faster and continue to reprice risk, with higher yields and mostly wider corporate and mortgage spreads.

There are subtle signs that the Fed’s restrictive policy is beginning to have the desired effect on a few forward-looking inflation indicators, and it is also impacting interest rate-sensitive sectors, such as housing. While core CPI remains near its local high (6.3%), core PCE has dipped from its February peak of 5.4% to 4.9%. Our preferred index is the full data set measure of the Underlying Inflation Gauge (UIG), which mirrors core PCE’s drop – it fell from 4.9% in March to the latest reading of 4.5% (for August).

One reason we favor UIG – besides its advertised goal of identifying the persistent component of inflation – is that it eliminates a lot of the monthly measurement noise and volatility that can plague the other indices. UIG shows a definitive peak and several months of falling inflation, which is a promising development in this fight to curb rising prices. Still, 4.5% remains well above target and much more work is left to be done.

Turning back to the Fed, we see little change in the trajectory of its current tightening policy. The most recent “dot-plot” of forward rate expectations of Fed members has recast higher to more realistic levels. The relative resilience of the economy pushes our expectation for that elusive terminal rate hike higher – and further into the future.