By Dr. Sonal Desai, Chief Investment Officer, Fixed Income, Franklin Templeton
The Fed is sending a strong signal that interest rates will remain higher for longer, as our Franklin Templeton fixed income CIO Sonal Desai has long predicted.this The Fed has also begun to acknowledge that the natural real interest rate is higher than it thought. She shares her latest insights on the policy outlook and its implications for investors.
The Federal Reserve kept interest rates on hold at its September meeting, but made a point of saying the neutral rate was likely to be higher than what the central bank has indicated so far, and that policy will have to remain tight for longer – as I have long maintained That way.
The Fed’s new “Summary of Economic Forecasts” reveals important changes in the Fed’s views and forecasts Compared to June. In terms of the macroeconomic outlook, the Fed now expects the economy to be stronger this year and next, with faster growth and lower unemployment. Gross domestic product (GDP) growth has been revised up by more than 1 percentage point to 2.1% this year and by nearly half a percentage point to 1.5% in 2024. The Fed currently expects the unemployment rate to be only 3.8% by the end of this year and only 4.1% in 2024 and 2025, while previous forecasts of unemployment rates are already quite low, at 4.1%, 4.5% and 4.5% respectively. However, the path of inflation remains almost unchanged, with core personal consumption expenditures (PCE) falling slightly this year to 3.7% (from 3.9%) and remaining unchanged at 2.5% next year, on track to be close to target by 2025.1
Some analysts were quick to criticize the forecast changes as inconsistent wishful thinking – predicting a stronger economy and labor market while maintaining the same deflationary path, they argued, was too optimistic.
I think the revised macro outlook will make sense once it is combined with new monetary policy forecasts and signals.
I have been arguing for some time that the natural real interest rate (the rate consistent with target inflation and full employment) is higher than the interest rate implied by the 2.5% long-term nominal interest rate in the Fed’s forecast. A higher natural rate would be consistent with the stronger growth we have been observing, and now the Fed’s new forecast acknowledges this. In fact, Fed Chairman Jerome Powell admitted that the reason the U.S. economy remains so strong is likely because natural interest rates are higher — in other words, current monetary policy isn’t actually that strict. (I would add that extremely loose and loose fiscal policy also contributed, as I argue below.)
Powell stressed that the natural rate is difficult to determine and stressed that if policy is restrictive, “we’ll know it when we see it.” We certainly haven’t seen it yet.
In fact, some Federal Open Market Committee (FOMC) members are now pointing to the natural rate being higher – with the upper end of the forecast range for the long-term federal funds rate rising to 3.3% from the previous 2.8%. I have argued in my previous On My Mind that the natural rate could be higher, above 4% (back in 2012, the FOMC set it in the 4.0%-4.5% range). In his post-meeting press conference, Powell reiterated more than once that the natural interest rate could be higher—a very important shift in emphasis, in my opinion, and a shift toward more realism.
FOMC members also left the door open for another rate hike before the end of the year (final rate was 5.6%, unchanged from June), and now expect a half-percentage point increase in the federal funds rate to 5.1% in 2024 and 3.9% in 2025. 3.9%. There are pretty strong signs that policy tightening will be longer.
My summary: The Fed realizes and implicitly acknowledges that policy is not tightening as much as it should, or at least, as Powell said at the press conference, not for long enough. This is reflected in strong economic growth and a strong labor market. Inflation has fallen, but not enough, and with the economy strong, monetary policy may not be tight enough and the deflationary process may stall.
To bring inflation back to target, further tightening of policy is needed. In the Fed’s scenario, this would be accomplished by keeping nominal policy rates high (with one more rate increase this year and up to two rate cuts next year), allowing lower inflation to lead to higher real interest rates.
It’s also worth noting that the Fed now acknowledges that the most important measure of real interest rates is contemporaneous inflation, not expected future inflation. In the early stages of tightening, the Fed often argued that policy rates were already in restrictive territory as measured by inflation expectations, especially mid- to long-term expectations. I’ve always believed that concurrent inflation is more important because that’s how consumers and workers feel. As the chart below shows, monetary policy has remained accommodative for much longer, as measured by contemporaneous inflation (PCE or Consumer Price Index) than by inflation expectations. The Fed’s focus now appears to be shifting more directly to comparing policy rates to actual inflation over the same period.
Chart 1: Federal funds rate versus expected and actual inflation
This combination of forecasts and policy signals may also be the most effective and least disruptive way to guide market expectations back to the old normal of high interest rates (pre-global financial crisis).
What are the risks to the outlook? Powell’s press Q&A highlighted a number of downside risks, from labor strikes to the looming threat of a U.S. government shutdown to the resumption of student debt payments to a possible spike in energy prices. I think a government shutdown is likely to have at best a modest temporary negative impact, while a surge in energy prices could reignite inflation and inflation expectations. Let us not forget that the latest forecast from the Congressional Budget Office shows that the fiscal deficit will account for about 7% of GDP this year, which means that the fiscal deficit has eased significantly from last year’s 5.5% of GDP.
I have long believed that investors should prepare for a return to the “old normal” of high interest rates – the long-term norm that preceded the unusually loose policy following the global financial crisis and COVID-19. The Fed now acknowledges that this is indeed the most likely scenario. The unstable fiscal outlook poses further upside risks to mid- to long-term yields. Financial markets have begun to accept this, but in my opinion the adjustment process will take longer and bring greater volatility.
what are the risks
All investments involve risks, including possible loss of principal.
equity securities Subject to price fluctuations and possible loss of principal.
Fixed income securities Involves interest rate, credit, inflation and reinvestment risks, as well as possible loss of principal. As interest rates rise, the value of fixed income securities declines. Lower-rated, high-yield bonds face greater price volatility, illiquidity and the possibility of default.
1. There is no guarantee that any estimate, forecast or prediction will come true.
Editor’s note: Summary highlights for this article were selected by Seeking Alpha editors.