Is the Fed Behind the Curve on Inflation?


Kevin Gale, Managing Director, Head of Fixed Income

From 1994 to 2020, the Federal Reserve’s preferred inflation measure, the Personal Consumption Expenditure Core Price Index (PCE), rose above 2.5% just briefly in 2006 and averaged 1.74%, well below the Fed’s target of 2% over time. Since the onset of the pandemic in early 2020, supply chain disruptions have negatively impacted the ability to obtain certain products in a timely fashion. This has led to higher prices for many products. In April of 2021, the PCE jumped to 3.08%, its highest level since 1991, and on October 31, 2021, the PCE rose even higher to 4.12%.

For months, investors and the Fed have been contemplating if the recent spike in inflation is transitory or a longer-term trend. In a speech on November 30th, 2021, Federal Reserve Chair Jerome Powell said the word “transitory” may not actually be the best way to describe the current high inflation environment we are in. This makes us think the Fed is behind the curve on fighting inflation. To intensify that sentiment, Powell also said the Fed needed to consider quickening the pace of its taper of monthly bond purchases, prior to that taper program even beginning.

For context, in early November the Fed announced that it would begin to reduce its monthly bond purchases by $15 billion per month beginning in December ($10 billion in Treasuries and $5 billion in mortgage-backed securities). The Fed has been consistently purchasing $120 billion of securities each month since June of 2020 ($80 billion in Treasuries and $40 billion in mortgage-backed securities). From March through May of 2020, the Fed had purchased significantly more to help reduce the impact of the economic shut down on the markets.

The Federal Reserve will likely increase the pace of its bond tapering sooner rather than later. In addition to a quickened pace of tapering, we would not take off the table the possibility that the Fed could begin to raise rates prior to completing its tapering, meaning it could still be purchasing bonds while raising interest rates.

The likely impact of the Fed being “behind the curve” is a flattening of the Treasury yield curve. As the Fed is increasing short-term rates to slow inflation, investors will become more concerned about the impact of those higher rates slowing growth. This could lead to short-term rates rising more rapidly than long-term rates, flattening out the yield curve. While it is tempting to maintain a fixed income portfolio of all short-dated maturities, we believe that may not be optimal in a flat yield curve environment, depending on your unique needs. A well-structured laddered portfolio will, in our opinion, continue to be one of the best long-term approaches for fixed income investments. It allows for the ability to re-deploy capital into different investments upon maturity alongside some continuous longer-term fixed income exposure if rates remain subdued due to slowing economic growth. Laddering remains a good way to diversify for both the knowns and unknowns that lie ahead.

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