The Powell Fed Is Headed to Central Bank Heaven

Investors are fortunate that the U.S. Federal Reserve appears to be heeding the lessons of history in its battle against inflation, its chief nemesis. Fed Chair Jerome Powell indicated as much last August in Jackson Hole, when he identified three lessons to apply from past inflation episodes:

1. Take responsibility for the inflation problem
2. Pay attention to inflation expectations
3. “Keep at it” until the job is done

Those lessons have led Powell and his colleagues to act aggressively, with the central bank announcing four successive 75 basis point (bp) rate increases last year through November – the Fed’s sharpest hiking cycle since Paul Volcker’s mammoth climb 40 years ago, which conquered the worst inflation problem in U.S. history. 

The success of Volcker’s actions, along with his subsequent fame, gave rise to the idea that only hawks go to central bank heaven. Powell appears to know this and is following Volcker’s hawkish path accordingly. Yet it remains challenging to fully grasp how far the “Powell press” will go, especially after the latest Labor Department report showed U.S. unemployment fell to a 53-year low in January. 

History Says the Fed Is Almost Done

For bond investors, it may be too soon to judge whether today’s Fed officials will make it to central bank heaven. Yet the pearly gates may be shining more visibly, thanks to an improved inflation outlook attributable to hawkish actions that just might pry those gates open. 

Still, how are investors to know? Temptations could surface that break the Fed’s resolve and turn the inflation outlook bleak again, sparking a rebound in bond yields and weakness throughout the financial markets. Moreover, if the Fed stays resolute, it may result in many more rate hikes than markets are priced for, leading to a potentially bad outcome for investors.

I would cast aside those worries and put faith in three indicators that suggest the Fed is nearly done with its rate hike journey:

1. The “proxy” federal funds rate in real terms compared with past inflation episodes: Fed policy is arguably tighter than the federal funds rate implies when a value is assigned to both quantitative tightening (QT) – the rolling off of Fed bond purchases – and forward guidance. That’s a rational approach when one considers the impact that QT appears to have had on the mortgage-backed securities market, for example, where yield spreads to Treasuries jumped by about 100 bps to over 200 bps, weakening the housing market considerably. That has value in terms of fed-funds equivalence. So does the Fed’s forward guidance, which affects broader financial conditions. Combining those two variables, the “proxy” federal funds rate is about 6.2%, according to calculations from the San Francisco Fed. Taking the analysis a step further to help answer the question, “is it enough,” we can subtract inflation expectations to arrive at the prospective real funds. That results in a rate of 3.5% to 4%, which looks high relative to history. It took a 3% real rate in the late 1960s to bring inflation down, and a 5% real rate in the early part of the Volcker era. Importantly, whereas Volcker had to set a rate that was fit for a decade-long problem, Powell may not need go as far, since his inflation problem is only two years old. 
2. Wage growth minus productivity: In my view, this is one of the better back-of-the-envelope equations to help guess where inflation is headed. It is a simple measure that captures the major factors that affect the cost of doing business. Recent data have moved favorably in this regard. Over the past six months, wage growth has slowed to about 4%. From that figure, subtract the 1.5% growth rate for productivity over the past decade or so and you get an inflation forecast of about 2.5%. Risks obviously abound for this equation, given the tightness of the labor market, which may well be structural. The hope on this front is that cyclical factors will help mitigate the upward pressure on labor costs and thereby reduce inflation pressures.
3. Market-based inflation measures: Market participants appear sanguine about the inflation outlook, judging by the market for Treasury Inflation Protected Securities (TIPS) and the 5-year/5-year forward breakeven rate, both of which are priced for the U.S. consumer price index (CPI) to fall into the low-2% area. Households are notably less sanguine than markets, but their sentiments tend to lag behind changes in realized inflation. I therefore would place greater emphasis on market-based measures. 

The Bond Market Outlook Remains Bright for 2023

I concede that solving the current inflation problem may require a higher policy rate than markets expect, and that the fed funds rate may have to stay higher for longer. Keeping at it is the only way for the Fed, after all, at least according to history. Yet, as I have said before, the size of any forecast miss for the funds rate this year is likely to be a lot less than it was last year, which should help reduce interest rate volatility this year. 

I therefore retain my favorable outlook for the higher quality segments of the bond market in 2023. At the center of this optimism is my faith in the Fed’s ability to control inflation and with it create conditions that result in attractive real rates of return for bond investors. That is why I think the adage “don’t fight the Fed” has a positive connotation for investors, which is to have faith in in the Fed’s ability to succeed, so long as the Fed continues to respect the lessons of history as I believe it surely will. 

Tony Crescenzi is a market strategist and portfolio manager at PIMCO and is also a member of the firm’s investment committee. Click here for more about Tony.

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