We think the Federal Reserve (Fed) is likely to hold its policy rate higher for longer. In a potential environment where U.S. rates are higher for longer, it may be prudent for investors to monitor the U.S. dollar’s movement.
Since March 2022, the Fed has raised its policy rate, the federal funds rate, eight times for an accumulated increase of 450 basis points. The target range for the federal funds rate is currently 4.50–4.75%, the highest since 2007. The Fed’s hiking campaign has been extremely aggressive. When will the Fed stop raising rates?
In Chart 1, the market consensus of the terminal rate is currently 5.26% and is expecting 75 basis-point hikes in total for the rest of the year, which would put the rate in the range of 5.25–5.5%. We believe the Fed will pause after those hikes and monitor inflation closely.
Inflation is the key driver of the Fed’s path forward. Federal Reserve Chairman Jerome Powell has continued to reiterate his commitment to bringing down inflation, and has been using a framework that breaks inflation into three buckets: Goods, Housing/Shelter, and Core Services Ex Housing. Goods inflation has come down, and housing-related inflation should begin to decline soon. Core Services Ex Housing represents more than 50% of the core inflation index and is now the main concern. In Chart 2, you will notice Core Services Ex Housing inflation is still running at more than 6% year over year. This bucket is mainly driven by wage growth and is a large contributing factor to the Fed continuing its hiking campaign. The Fed needs to see continuous disinflation in wage growth to be comfortable pausing its rate hiking campaign, so it’s wise to keep a eye on the labor market—especially wage growth.
The latest nonfarm payroll report from 3/10/23 does not make the Fed’s job any easier. There was a net increase of 311,000 jobs—much higher than economists’ expectation of 225,000. The labor market is very strong with an unemployment rate of 3.6%. The average hourly earnings and the Atlanta Fed’s Wage Growth Tracker, two key indicators of wage growth, show growth still above normal levels (Chart 3), which leads us to believe that the Fed will continue to remain diligent in its effort to bring down inflation.
Better safe than sorry? It is likely that the Fed may overtighten in the process of cooling down the job market and push the U.S. economy into a recession. The Fed is aware of the lagging nature of labor-market indicators and monetary actions, but according to comments from Chairman Powell and other members of the Federal Open Market Committee (FOMC), the risks associated with under tightening seem to be greater than those of overtightening. If the Fed overtightens with inflation and wage growth under control, it can use its typical approach of easing monetary policy to facilitate economic recovery, so it is the easier path.
However, fighting against long-term high inflation is a different and much more difficult task: The economy could suffer more under long-term elevated inflation (or even stagflation) due to under tightening.
The last time the Fed had to fight hard on inflation was in the late 1970s and early 1980s. In that period, the Fed initially responded too dovish and had to re-tighten to bring down inflation, severely damaging the economy. No current FOMC members held positions back then, but they are astute students of economic history and theories and have learned from that experience. They may opt for some unpopular measures to ensure the inflation dragon is slayed.
The Fed has taken historic measures to curb inflation, and we believe the Fed’s interest hikes are not quite done. A growing paycheck might sound good, but that wage pressure is what is keeping inflation high and the Fed diligent in its efforts. Since overtightening is not the worst-case scenario, we believe the Fed is erring on the side of caution. As a result, markets could remain volatile until the picture becomes clearer. In a potential higher-for-longer U.S. rates environment, it might be prudent for investors to monitor the U.S. dollar’s movement, stay flexible with their allocations, and adjust among different global asset classes in alignment with their investment goals.
For more insights from Pacific Life, visit PacificLife.com
This commentary represents the views of the portfolio managers at Pacific Life Fund Advisors LLC as of 2/27/23 and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant.
This material is provided for informational purposes only and should not be construed as investment, tax, or legal advice. Information is based on current laws, which are subject to change at any time. Clients should consult with their accounting or tax professionals for guidance regarding their specific financial situations.
Pacific Life refers to Pacific Life Insurance Company (Newport Beach, CA) and its affiliates, including Pacific Life & Annuity Company. Pacific Life Insurance Company is the issuer in all states except New York. Pacific Life & Annuity Company is the issuer in New York.
Pacific Life, its distributors, and respective representatives do not provide tax, accounting, or legal advice. Any taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor or attorney.
Pacific Life is a product provider. It is not a fiduciary and therefore does not give advice or make recommendations regarding insurance or investment products.
Pacific Life refers to Pacific Life Insurance Company and its affiliates, including Pacific Life & Annuity Company. Insurance products are issued by Pacific Life Insurance Company in all states except New York and in New York by Pacific Life & Annuity Company. Product availability and features may vary by state. Each insurance company is solely responsible for the financial obligations accruing under the products it issues.
Variable insurance products are distributed by Pacific Select Distributors, LLC (member FINRA & SIPC), a subsidiary of Pacific Life Insurance Company (Newport Beach, CA) and an affiliate of Pacific Life & Annuity Company. Variable and fixed annuity products are available through licensed third parties.
No bank guarantee • Not a deposit • Not FDIC/NCUA insured • May lose value • Not insured by any federal government agency
For financial professional use only. Not for use with the public.