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Fed Accelerates Inflation Fight with Half-Point Rate Hike

By allowing inflation to escalate for a year while keeping interest rates near 0%, central bankers are radically behind the curve.

Close-up of the back of a United States bill.

Key Takeaways

The Fed executed its first half-point rate hike in 22 years, lifting short-term rates to 0.75% to 1%.

With inflation sitting at a 41-year high and the economy slowing, the Fed faces an uphill battle to tame soaring prices without triggering a recession.

Rising rates highlight the need for investors to stay defensive and opportunistic with bonds, in our view.

Short-Duration Bonds May Aid Investor Portfolios as Interest Rates Rise

The Federal Reserve (Fed) turned its tightening plan up a notch, announcing a half-point increase in short-term interest rates on May 4. The federal funds rate target now sits at a range of 0.75% to 1.00%, while the annual headline inflation rate hit 8.5% in March.1

While money market investors will nab higher yields, those holding other fixed-income assets likely will face more bumps in the road. Nevertheless, we believe implementing a defensive fixed-income portfolio strategy with short-duration bonds may help smooth the ride.

The Fed Continues to Play Catch-Up

The Fed hasn’t executed a half-point rate increase since May 2000. The larger-than-typical rate hike follows a quarter-point lift in March and highlights the intensifying challenge. By allowing inflation to escalate for a year while keeping interest rates near 0%, central bankers are radically behind the curve.

Catching up remains a momentous task complicated by war in Ukraine, mounting geopolitical unrest, record gas and commodities prices, and supply chain disruptions. And now, the 1.4% annualized decline in first-quarter U.S. economic output has added an additional obstacle.

Usually, when the Fed raises rates to tame inflation, the economy is growing. Higher interest rates tend to slow economic growth, which typically tempers inflation. Today, the Fed is tightening as the economy is slowing, a combination that boosts the risk of recession.

In our view, it’s a risk the Fed recognizes but has little room to avoid, given its failure to tackle the inflation threat early on. We believe taming inflation will require the Fed to maintain an aggressive approach. This effort will likely include executing additional 50-basis point (bp) rate hikes and reducing its swelling balance sheet.

Because of the Fed’s massive monetary support programs, the central bank now holds a record $9 trillion in Treasuries and mortgage-backed securities. Starting in June, the Fed will allow up to $47.5 billion of these bonds to mature monthly without reinvesting the proceeds. The runoff will jump to $95 billion in September, and over time, this effort should further tighten financial conditions by raising long-term interest rates.

Stagflation Risk Is Mounting

Along with recession, the risk of stagflation is also rising. A permanent blemish on the 1970s, stagflation occurs when inflation is high and economic growth is stagnant.

Like the 1970s, oil prices and inflation have surged in recent months and economic growth has stalled. Unlike the 1970s, today’s labor market is strong, and despite the first-quarter setback, we still believe the U.S. economy can expand for the year overall.

However, we believe stagflation poses a more imminent risk in Europe. Growth outlooks throughout the region have plummeted amid soaring energy prices and record-high inflation. And as an added challenge, Russia is the leading energy supplier to the region.

This scenario leaves the European Central Bank (ECB) in a bind. Unlike the Fed, ECB policymakers have, for now, chosen to support economic growth rather than tame inflation. The ECB plans to end its bond-buying program in the third quarter, but it has no immediate plans to lift interest rates off 0%.

Meanwhile, the Bank of England already has lifted interest rates three times, as the country deals with its highest inflation rate in 30 years. Elsewhere, the Bank of Canada increased its key lending rate 50 bps in April, its largest rate hike in 20 years.

Inflation Is Likely to Persist

Some economic pundits recently have suggested U.S. inflation is at or near a peak. In our view, it’s too early to make that call. Amid raging geopolitical unrest, we believe inflation is unlikely to ease meaningfully in the near term.

Russia’s invasion of Ukraine continues to have a devastating effect on food, energy and fertilizer supplies and prices. Elsewhere, China’s lockdown of key cities is harming already-stressed supply chains.

Recent earnings reports confirmed supply chain breakdowns remain an ongoing threat to corporate profitability. On the other hand, if the global economic slowdown gathers momentum, demand likely will dampen. This, in turn, could help ease inflationary pressures.

Our best-case scenario calls for inflation to start easing later this year. The key question is where it will settle. In our view, inflation will remain well above pre-pandemic levels until:

  • Supply dynamics improve in the energy commodities sectors, labor markets and manufacturing.

  • Demand trends meaningfully slow down or even contract.

  • Real interest rates (rates adjusted for inflation) turn positive.

Should I Still Own Bonds?

Today’s volatile market highlights the role bonds play in your diversified portfolio. While periods of rising rates and inflation can be challenging for bond investors, it’s important to remember why you own bonds in the first place. They seek to provide a steady stream of income and may help reduce the effects of stock market volatility on your overall portfolio.

It’s important to keep in mind rising rates and higher inflation tend to pressure longer-maturity Treasuries and other high-quality bonds. But shorter-duration bonds typically have less price sensitivity to rising rates.

Within the short-duration space, we believe select credit-sensitive and floating-rate bonds offer income advantages over government securities. Although these securities are riskier than government bonds, security selection and active management may help reduce some of those risks.

Also, bonds have historically declined in value during the early months of a rate-hike cycle. But, as interest rates rise, investors can reinvest the proceeds from coupon payments and maturing bonds at higher interest rates. This may improve returns over time.

Stick With Your Plan

Investors are facing extraordinary challenges from geopolitical unrest and shattered supply chains to soaring consumer prices, rising interest rates and stalled economic growth. While the mix of investor antagonists is unusual, the resulting market volatility is not.

Regardless of the backdrop, we encourage investors to remain disciplined and avoid reacting to short-term market swings. In our view, investing across multiple asset classes and sectors, focusing on risk management, is a sensible approach given current market conditions.

It’s also important to remember that market unrest often creates investment opportunities. We suggest investing with experienced professionals with the insights, conviction and discipline to recognize and potentially capitalize on attractive opportunities when they’re significantly undervalued.

For more views on inflation and investing, please see our March 22 article, “Fed Tackles Mounting Inflation with Belated Rate Hike.”

Charles Tan
Charles Tan

Co-Chief Investment Officer

Global Fixed Income

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