On My Mind: Overdue Reality Check for Fed and Markets Has Barely Begun

This article, authored by Sonal Desai, Ph.D., Chief Investment Officer, Franklin Templeton Fixed Income, was first published in the Financial Times on May 23, 2022.

The US Federal Reserve (Fed) and financial markets are experiencing a long overdue reality check on inflation and interest rates. But markets have barely begun to take into account how far the world has changed.

I believe they are still experiencing a severe case of cognitive dissonance. Inflation has surged to levels not seen since the infamous 1970s and remains stubbornly high. The Fed has started tightening, with policy rates already moving up, and the central bank set to shrink its balance sheet after ending its market-boosting asset-buying program.

But even after the evidence of inflation rises in recent weeks, most investors still expect interest rates will not rise very much and will not remain elevated for very long. I think this may be very misguided.

Markets anticipate that US economic growth will slow as we head into 2023—and here I would agree. High inflation has taken a toll on purchasing power and will hurt household consumption, even though real income still exceeds pre-pandemic levels. Supply chain disruptions continue to hamper production, and the combination of somewhat tighter monetary policy with less generous fiscal stimulus will hold back activity.

Financial markets have been conditioned to believe that the Fed will react to this slowdown in growth in the same way it always has in the post-financial crisis period: by loosening monetary policy quickly and decisively. This is where I expect things will play out differently.

This time when growth slows, inflation will in all likelihood still be too high for the Fed to stop tightening. Month-on-month headline consumer price inflation has averaged 0.6% since the start of last year. Even if that monthly pace halves, inflation will end 2022 close to 6.0% year-over-year (Y/Y), and will be running at an average of 4.5% in the first quarter of 2023.