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Fixed Income
Inflation

Does the Fed’s Pause Finally Mean Mission Accomplished?

After 10 rate hikes, slowing inflation and other economic trends should help push the Fed over the finish line.

06/14/2023
Exterior of Federal Reserve building.

Key Takeaways

Despite the hawkish tone accompanying the Fed’s announcement, we doubt policymakers will need to restart rate hikes in the coming months.

Moderating inflation combined with slowdowns in other economic data and credit availability should keep the Fed on the sidelines for a while.

A late-year recession remains the most likely outcome, highlighting the importance of risk management in investment portfolios.

Fed Takes a Break

For the first time in 15 months, the Federal Reserve (Fed) held interest rates steady on June 14. Lingering concerns about banking industry stress contributed to the decision to keep the short-term rate target in a range of 5% to 5.25%.

The Fed has been on a rate-hike rampage, facing persistently high consumer prices that threaten its inflation-fighting credibility. Taking a break finally gives policymakers time to assess the lagging effects of the fastest-tightening campaign in 40 years. It also allows the Fed to gauge the health of the broad banking industry and the state of credit creation.

Will the pause be permanent, or will the Fed launch a rate-hike reboot later this summer?

Fed’s Hawkish Outlook May Not Last

Fed Chair Jerome Powell’s relatively hawkish tone during his June 14 press conference left the door open for additional tightening. But we don’t believe more rate hikes will be necessary. Recent inflation, wage growth and other economic data indicate the Fed’s efforts are working.

Headline Inflation Retreats

Former Fed official Esther George recently confirmed that while the Fed considers various economic indicators, none is as influential as inflation data. The Federal Reserve Bank of Kansas City’s former president took viewers inside the Fed’s dilemma during an American Century webinar.

Since June 2022, the annual headline inflation rate has moderated. The latest reading showed a drop from 4.9% in April to 4% in May, as energy prices plunged. Headline inflation growth now stands at less than half its June 2022 peak of 9.1%.

Core inflation (minus food and energy costs) growth also has eased, though slowly, since peaking at 6.6% in September. The annual core inflation rate fell from 5.5% in April to 5.3% in May, still notably higher than the Fed’s 2% target. Stubbornly high services costs, fueled mainly by rising shelter costs and a resilient labor market, have been key culprits.

Labor Market Data Mixed, While Wages Slowly Soften

The May jobs report featured a robust 339,000 gain in nonfarm payrolls, highlighting persistent inflationary pressures. In addition, the Bureau of Labor Statistics revised upward the payroll data for March and April. However, it’s important to note that large revisions to job figures may occur at business cycle turning points.

Conversely, the separate (and smaller) household employment survey indicated a sharp drop in employment, which lifted the unemployment rate to 3.7% from 3.4% in April. The divergence likely was due to a sharp decline in self-employed Americans, captured in the household survey but not nonfarm payrolls.

Meanwhile, wage growth, another key driver of rising inflation, appears to be slowly softening. After peaking at an annualized rate of 6.7% in June 2022, wage growth steadily slowed to 6.0% in May.

Tighter Credit Conditions Aid Fed’s Efforts

Although the economy and inflation haven’t yet slowed to the Fed’s liking, a potential credit crunch has put policymakers on guard. Following several high-profile bank failures, the banking industry remains stressed and under scrutiny.

Financial firms began reining in their lending activity in the first quarter, well before markets realized the full effects of the bank failures. The Fed’s April Senior Loan Officer Opinion Survey on Bank Lending Practices showed that most banks implemented tighter standards for business and consumer loans.

We expect a continued slowdown in lending activity, which would further help the Fed achieve its goals. As the pullback in credit creation filters through the economy, job growth, consumer spending and inflation should continue to temper.

History Offers Clues to Tightening Cycles

It’s important to note that at its current range of 5% to 5.25%, the Fed’s short-term rate target remains higher than the headline inflation rate. This has proved to be a key metric in ending hiking cycles dating to 1973, as illustrated in Figure 1.

Figure 1 | Peak Rates Have Consistently Topped Inflation

Tightening Cycle

Federal Funds Rate Peak

Date

Headline Inflation

Real Federal Funds Rate

Unemployment Rate at Peak Federal Funds Rate

1973

11.00%

8/30/1973

7.4%

3.60%

4.8%

1976-1980

20.00%

3/3/1980

14.8%

5.20%

6.3%

1980

20.00%

12/5/1980

12.5%

7.50%

7.5%

1983-1984

11.75%

8/24/1984

4.3%

7.45%

7.5%

1986-1989

9.75%

2/24/1989

4.8%

4.95%

5.4%

1994-1995

6.00%

2/1/1995

2.9%

3.10%

5.6%

1999-2000

6.50%

5/16/2000

3.2%

3.30%

3.8%

2004-2006

5.25%

6/29/2006

4.3%

0.95%

4.6%

2015-2018

2.50%

12/19/2018

1.9%

0.60%

3.8%

2022-2023

5.25%*

6/14/2023

4.0%

1.25%

3.7%*

Data as of 6/14/2023. Sources: FactSet, Bianco Research LLC. *If rate hikes ended 6/14/2023.

Additionally, in the past 50 years, the Fed always ended a tightening campaign when the real federal funds rate (federal funds minus headline inflation) was positive. The most recent tightening cycle (highlighted in Figure 2) shows that the real federal funds rate turned positive earlier this year. We believe this dynamic further supports our view that the Fed’s target lending rate has likely reached its peak.

Figure 2 | Changing Rates, Inflation Relationship Suggests Fed Policy Working

Combination chart comparing the Federal Funds Rate to CPI while also showing the real Federal Funds Rate. Federal Funds Rates are rising while CPI is falling, since May 2022.

Data from 5/31/2022 – 5/31/2023. Source: FactSet.

Recession Is Still in Our Forecast

The U.S. economy has remained remarkably resilient despite historical jumps in interest rates and inflation over the past 15 months. Nevertheless, a slowdown appears to be unfolding — another reason we don’t expect another Fed rate hike.

While the employment figures remain strong, other key economic data paint a different picture. For example:

  • The manufacturing sector contracted for the seventh consecutive month in May, per the ISM Manufacturing Purchasing Managers’ Index.

  • Home prices have steadily declined for the past year, according to the S&P CoreLogic Case-Shiller Home Price Index. In March, the index posted its first year-over-year decline since May 2012.

  • Year-over-year retail sales growth has dwindled, from 9.3% in June 2022 to 1.6% in April, as reported by the U.S. Census Bureau.

Higher interest rates also continue to filter through the economy and should curb consumer and business spending. We also expect banks to slash their risk exposure and impose stricter standards for all types of loans. We believe these factors will ultimately cool the jobs market and push the unemployment rate higher.

Discipline, Long-Term Investment Focus Remain Crucial

We encourage you to remain disciplined and focused on your long-term investment plan during heightened market and economic uncertainty. Making knee-jerk responses to short-term market swings or temporary economic setbacks could derail your strategy.

Instead, investing across multiple asset classes with professional investors skilled in risk management may be prudent in the current market climate. Our investment teams have been anticipating an economic slowdown and positioning our portfolios accordingly. Given our outlook for recession, we believe an emphasis on higher-quality equity and fixed-income securities remains warranted.

It’s also important to remember that attractive investment opportunities may emerge during market unrest. We suggest investing with experienced professionals with the insights and discipline to recognize and potentially capitalize on such prospects.

Author
Charles Tan
Charles Tan

Co-Chief Investment Officer

Global Fixed Income

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The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

In certain interest rate environments, such as when real interest rates are rising faster than nominal interest rates, inflation-protected securities with similar durations may experience greater losses than other fixed income securities. Interest payments on inflation-protected debt securities will fluctuate as the principal and/or interest is adjusted for inflation and can be unpredictable.

Generally, as interest rates rise, the value of the securities held in the fund will decline. The opposite is true when interest rates decline.

Diversification does not assure a profit nor does it protect against loss of principal.