Handicapping the Fed's Fight Against Inflation

The Federal Reserve recently raised short-term interest rates at its September meeting, marking the fifth rate hike this year with more increases likely in the offing. The move is part of the central bank’s broader policy approach to combat record levels of inflation and stave off a prolonged recession. Despite today’s soaring consumer prices and waning business confidence, the Fed has been through tough economic times before and has a range of tools at its disposal.

We don‘t believe a recession is already underway. While it’s not a certainty, a recession is unlikely given the strong economic data we’ve seen recently including job gains, rising wages and resilient business confidence. However, economic growth is slowing due to rising interest rates and waning consumer confidence. Today’s inflation is unique in that it doesn’t stem from the usual catalysts, namely the Phillips Curve tradeoff between unemployment and inflation or the “guns vs. butter” argument that spending on the Vietnam War and Lyndon Johnson’s Great Society crowded out other investments. The shock from higher energy prices due to Russia’s invasion of Ukraine is somewhat akin to that of the oil embargoes of the 1970s and 1980s. Still, the U.S. economy is far less dependent on imported oil today. Fortunately, U.S. policymakers appear to have learned that resorting to price controls and rationing can lead to more economic pain and disruption—not less.

In our view, the Fed is meeting the challenge of today’s spike in inflation with relatively clear and transparent language. Remember, the Fed has a long memory when it comes to past policy decision paths. The Fed does its best to hash out incremental policy changes to achieve its dual mandate to achieve maximum employment with low, stable inflation. Changes to the Fed’s views and policies can have a profound impact on markets and investors. That means every word in Fed statements are carefully dissected. While the Fed is not infallible, history has shown that it has the ability to correct its mistakes to steer the economy in the right direction.

Consumer and business expectations of inflation are key determinants of whether higher prices “stick” and it took a long time for inflation rates to come down after the oil crisis in the 1970s and early 1980s. But inflation moderated during the 1990s and the core rate (excluding food and energy prices) remained near 2% from the mid-1990s until 2020. As for how much control the Fed actually has over inflation is a tricky question. Today’s high inflation is not “made in the USA” but rather a global phenomenon related to supply-chain disruption. That disruption has been driven by Covid-19 and the energy supply crisis stemming from Russia’s invasion of Ukraine. While many economists have argued that U.S. fiscal policy was too generous in addressing Covid-19 and that this overreach contributed to excess demand for supply-constrained goods, other nations with less aggressive fiscal policies are facing the same inflationary pressures.

In 2012, the Fed initiated a 2% inflation target under then-Chairman Ben Bernanke but that target had been in place informally since 1996. Just a few years ago, when the unemployment rate was nearing a 50-year low and the core inflation rate was below 2%, many economists questioned whether the 2%target was too low. Was it allowing the economy sufficient “lubrication” to achieve higher growth rates that would lift wages? In our view, that period of low inflation was fueled by the globalization of production and technological innovations—robotics on the factory floor, algorithms and software innovations that increased productivity, for example. These technological trends are likely to reemerge once supply chains normalize and businesses find new ways to maximize production in the face of a scarcity of skilled labor. The appropriate inflation target is the subject of much debate particularly in a world of flexible exchange rates and mobile capital. Still, we think inflation far above 3% should be avoided.

In periods of higher inflation, we tend to favor stocks over bonds. In many sectors, companies are able to pass on their higher input costs into the prices of their goods and services, thereby preserving margins. Bonds become more risky when inflation rates rise so we recommend that income-seeking investors maintain an allocation to dividend-paying stocks and bonds. Dividends can offer investors the chance to “get paid while you wait,” with the potential to see these stock prices rise over time.

We expect the Fed to continue to raise rates until the economy slows enough to keep inflation in check. Right now, we are seeing signs that this has begun to happen as both businesses and consumers have curbed their enthusiasm and are becoming more price selective. Still, we expect the Fed to remain sensitive to the strengths and weaknesses of the U.S. economy, and its understanding that prices tend to be a lagging indicator suggest that they’ll need to pivot toward a less restrictive policy before inflation rates bottom. Given that this inflation surge is a global problem, it’s a tall order for the central bank to achieve and we can’t rule out the possibility of a recession.