The Treasury market repriced in the first quarter to be more aligned with Fed guidance
Many are still expecting a soft landing for the U.S. economy, but that scenario will likely depend on inflation moving lower in a timely manner
Fed leaders are hoping to avoid a repeat of the mistakes of the 1970s, and the resilience of the labor market affords policymakers more patience in pivoting to rate cuts
The Treasury market repriced in the first quarter to be more aligned with Fed guidance, and the historically elusive soft landing is still considered a likely outcome by many market participants and economists alike. A soft landing would entail the Fed successfully bringing inflation down to its 2% target while avoiding a recession. Will it actually happen? The jury is still out, and the path of inflation will have the largest say in all of this. Year-over-year measures of core inflation have come down notably from the peaks of 5%-7% in 2022 but remain well above 2%. At the same time, the Fed’s other mandate, full employment, remains at a satisfactory level, affording policymakers greater patience in pivoting to a more accommodative position.
Some shorter-term measures of inflation have drifted higher in recent months and are likely causing consternation for Fed leaders. The Atlanta Fed produces a sticky-price CPI metric, which tracks 21 underlying components (out of 45 total) that tend to be less volatile over time. Exhibit 1 observes the 3-month annualized change in this metric. After reaching a cycle high of 7.5% in June 2022, the index fell to 3.6% last July. However, it has risen over the last 7 months to 5% in the most recent February reading. If you are a Fed leader watching this trend while the unemployment rate is holding near a 50-year low, are you in a hurry to cut rates? The likely answer is no, which most have conveyed in recent speeches and the March 20 FOMC meeting.
Exhibit 1
Memories of Past Mistakes
Dubbed the Great Inflation, the period of the late 1960s to the early 1980s was marred by stubbornly high inflation and periods of high unemployment (“stagflation”). Research pieces over the years have suggested that the Fed’s decision to prematurely pull back from policy tightening in the late 1960s fueled the stagflation of the 1970s before the Paul Volcker-led Fed dropped the hammer in the early 1980s, raising the fed funds rate to 20%. The Fed has few, if any, good choices to combat stagflation. When the economy slows and unemployment rises, policymakers would typically respond by cutting interest rates and increasing the level of monetary reserves in the system. However, when inflation is already well above the Fed’s target, easing policy could push inflation even higher. This is not something a Fed leader wants for their legacy.
To be clear, this isn’t the 1970s, and such comparisons are perhaps too simplistic. However, current economic conditions give Fed leaders an opportunity to be more patient. Would softer employment data in consecutive months be enough to change their minds? Perhaps so. If, at the same time however, inflation remained elevated at current levels or even ticked higher, Fed leaders would have an even greater dilemma. It’s not an easy job, and economic data is rarely perfect in real time.
Another concern related to a premature policy pivot was recently expressed by Atlanta Fed President Raphael Bostic (2024 voter). Bostic currently expects one rate cut in 2024, and despite making much progress on the inflation front, he worries about something he referred to as “expectant optimism” in the business community. In speaking with business executives, they suggested pent-up demand for hiring and capital investment. “I asked one gathering of business leaders if they were ready to pounce at the first hint of an interest rate cut,” said Bostic. “The response was an overwhelming yes.” These are undoubtedly difficult decisions to make in the coming months, and with uncertainty comes rate volatility, as has been the case for more than two years now. What would likely help cool the economy would be slower household consumption as the year progresses, which was one of our economic themes entering 2024.
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