Between the Fed and a Hard Place


Kevin Gale, Managing Director, Head of Fixed Income

Soaring inflation and rising interest rates have led to questions on how the Federal Reserve will be able to engineer a soft landing for the economy. Historically, as the Fed begins to raise rates, slowing economic growth will lead to lower inflation. Just like every other time, it seems that this time may be different. Massive disruptions in the supply chain combined with the “great resignation” and excessive monetary and fiscal stimulus have led to soaring inflation that the Fed may struggle to control. This leads us to question whether the Fed will be able to engineer a soft landing or if it will be harder than intended.

A soft landing is when the Federal Reserve can slow economic growth and curb inflation without putting the economy into a deep recession, or negative GDP (Gross Domestic Product) growth. In a recent interview on May 12th, Federal Reserve Chairman Jerome Powell commented that “A soft landing is really just getting back to 2% inflation while keeping the labor market strong.” A hard landing occurs when the Federal Reserve overshoots its rate hikes (pushing rates too high too quickly), thereby pushing the economy into a rapid decline in growth followed by a flat-to-low growth period.

The challenge the Federal Reserve has is two-fold. First, various stimulus packages, some of which are highlighted below, totaling about $9 trillion were introduced from March 2020 through March 2021. To put into perspective the amount of stimulus injected into the U.S. economy, in 2020 the total GDP of the United States was just under $21 trillion. Secondly, the supply side of the global economy remains an issue. With China taking a hard zero COVID policy stance, global disruptions of the supply chain are expected to continue.

Some highlights of the Federal Reserve’s Response to COVID:

  • March 15, 2020 – Cuts interest rates to 0%, announces it would purchase “at least” $700 billion of treasury and mortgage-backed securities over the coming months, with no limit. Ultimately, the Fed would purchase $4.1 trillion of securities, finally ending purchases in March 2022.
  • March 17, 2020 – Announces the creation of a new facility to purchase as much as $1 trillion of corporate bonds and commercial paper.
  • April 6, 2020 – Announces three new Emergency Lending Facilities totaling $1.95 trillion.
  • April 27, 2020 – Announces the expansion of Municipal Lending Facilities to $500 billion.
  • June 15, 2020 – Main Street Lending Facility opens, providing emergency lending of $600 billion to small businesses.

Some highlights of fiscal stimulus provided for COVID relief:

  • March 27, 2020 – $2 trillion CARES Act stimulus package was passed.
  • December 20, 2020 – $900 billion COVID Relief package passed.
  • March 10, 2021 – $1.9 trillion American Rescue Plan passed.

With the amount of fiscal and monetary stimulus provided over the past two years, combined with the challenging supply chain environment and shortage of workers, the Federal Reserve may have a very difficult job slowing inflation without significantly slowing the economy.

The initial stages of this effort by the Federal Reserve have begun. At its last two meetings, the Committee has raised short-term interest rates by a combined 0.75% and has ceased any further quantitative easing (purchasing of treasury and mortgage-backed securities). The Fed will now actually begin quantitative tightening by selling some of its holdings of treasury and mortgage-backed securities. The selling of securities could modestly increase interest rates as the process unfolds over time.

Although Chairman Powell defined a soft landing as getting back to 2% inflation while keeping the labor market strong, we believe the Fed could allow inflation to run above its stated long-term goal of 2% for an interim period, if that meant avoiding a recession. If the Fed can push inflation down to the 3-4% range in the near-term while maintaining a strong labor force, we would consider that a successful soft landing. Pushing inflation closer to the long-term goal of 2% will require the supply chain to begin to heal or the Fed to make the tough decision of continuing to raise rates, putting the economy at an increased risk of a recession over the next 12-18 months.

We believe the best way to defend against the uncertain near-term outlook is to maintain a well-diversified portfolio across multiple asset classes. A diversified higher-quality equity portfolio combined with fixed income and alternative investments can help cushion downside risk while maintaining the potential for portfolio growth.

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