Duel of the mandates – UBS

Another five or six hikes in 2022 can also be expected, barring a severe negative growth shock. But beyond that, the policy path and its market implications are murkier. There are a number of reasons, one being the uncertainty over which half of the Feds dual mandateprice stability and full employmentwill take priority once monetary policy gets close to neutral, and the Fed is confronted with the hard decision of how much further to go.

For much of last year the Fed prioritized labor market recovery, and implicitly growth, over inflation. The latter was considered transitory, while the Fed thought there was still ample slack in the labor market because many people had not yet returned due to pandemic-related issues. That thinking pivoted by December, as did Fed communicationthe labor market is now tight and inflation is at risk of being persistent and unanchored. Consequently, the Fed is in inflation-fighting mode. But after inflation has moderated and growth has slowed, the pendulum between the two mandates is likely to swing back.

The market isnt waiting, as its already pricing in a rate cut in 2024, after over 200bps of rate hikes in 2022 and 2023. This despite the market also pricing CPI inflation to still be near 3% at the time. With many factors influencing market pricing, this shouldnt be interpreted literally as the Fed prioritizing full employment by 2024. But it does beg the question of what will be driving the Feds policy calculus one to two years out. The following are some factors that Fed officials may consider when trying to balance both aspects of their mandate.

First, it may take a significant rise in the unemployment rate to have a material effect on inflation. Using the Phillips curve inverse relationship between inflation and unemployment, and plugging in current levels for both, suggests that unemployment would have to rise to around 10% for inflation to even get close to the 2% target. There are many limitations and valid criticisms of the Phillips curve, but it does provide some perspective on how high unemployment may have to go in order for inflation to come back down to 2%, which may be a cost the Fed is unwilling to bear.

Second, the labor market is historically tight, and its possible that demand destruction within the labor market due to Fed tightening may actually bring supply and demand back in line and moderate wage growth, rather than lead to large job losses. Thats a big if, and history isnt supportive; a 50-100bps rise in the unemployment rate has always been followed by a recession. But its also true that demographics and the long-term decline in labor force participation have never been this conducive to the labor market remaining tight. This may lead the Fed to think that monetary policy can be at least slightly restrictive without risking full employment.

Third, there is a market dislocation argument for the Fed to let inflation stay elevated for a while, if necessary. The stimulus-induced aggregate demand surge in the US economy and the supply-side bottlenecks not only drove headline inflation to nearly 8%, but they also distorted the relative prices of goods, services, and labor. This matters because relative prices determine the resource allocation in the economy, and distortions lead to economic inefficiencies. With the economy, hopefully, moving into the endemic stage of COVID and the effects of the pandemic shocks receding, relative prices can again properly perform their market-clearing function. This will take some time, which the Fed understands. Hiking too much and too soon to curtail a rising absolute price level could prematurely truncate this resource reallocation process.

Fourth, the Fed may be willing to tolerate inflation near or above 3% for a sustained period, as long as the secular trend is toward lower inflation, and it doesnt appear to be re-accelerating. Publicly, the Fed will stay committed to a 2% inflation target to maintain its inflation-fighting credibility. But as a practical matter, if Fed tightening in 2022 combined with a natural moderation is enough to get inflation near 3%, the Fed may well take a measured pace from thereon to get to the neutral policy rate or slightly above to minimize recession risk.

The Feds goal at the start of any hiking cycle is to engineer a soft-landing for the economy. Thats never easy and history doesnt indicate a great track record. The Feds task this time is further complicated by it already being so far behind the curve, with inflation not being this high since the early 1980s. That brings up the possibility that Fed Chair Jay Powell will channel his inner Paul Volcker, hiking rates so much to bring down inflation that a recession is all but inevitable.

That is a risk, but the mid-1990s hiking cycle might be a better template, based on the considerations listed above. The Fed began hiking rates in January 1994 and was done by February 1995, with the funds rate going from 3% to 6%. There were even three 50bps and one 75bps rate hikes. Inflation was 2.7% when hiking began and 2.9% when it ended, and stayed in that range for two years before falling below 2% in 1998. Todays starting inflation is much higher, but the Fed would gladly take that inflation profile for the rest of this cycle.

Rather than Volcker, the 1990s approach of his protg Alan Greenspan might be the more appropriate reference for what to expect from the Fed. This is not an official forecast for what the Fed will do, but simply speculation on how it will think about conducting monetary policy over the next year or two. Something investors will likely be doing rampantly in the months ahead.

Main contributor - Jason Draho

Content is a product of the Chief Investment Office (CIO).

Read original blog - Duel of the mandates, 16 March 2022.

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Duel of the mandates - UBS