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Is the Fed in control of inflation? Not yet

16 June 2022

As largely expected, the Federal Reserve lifted rates by 75 basis points, the largest increase since 1994. Chairman Powell promised potentially the same at the next meeting, leading to a rapid pace of rate hikes up to a terminal rate that is almost as exactly as priced into Fed Fund futures (see Dot Plots graph below). The Fed tried to put a positive spin on growth to anchor expectations amongst households but its forecasts have been revised lower. As a consequence, US equities and bonds rallied amid profit taking before giving up gains the following day. There is little evidence of the Fed gaining credibility yet in break-even inflation and the guidance given by the Fed remains under scrutiny.

Source: Nordea Investment Funds S.A. and Bloomberg

Will the terminal rate convince the market? Will consumption slow and surveys such as the business Beige Book or household Michigan adjust? Those are the key indicators to watch. Another point of attention is the real estate market, where an enormous amount of wealth is stored and leverage is high. Given that real estate prices have surged sharply on scarce supply, house prices have by definition significantly overshot the mark. There is already evidence of fewer competition amongst buyers faced with much higher mortgage rates. The question is when will the house of cards come down. Is it slow and delayed or rapid? The odds are that prices adjust lower fairly rapidly but settle down as this shouldn’t be anywhere close to the subprime crisis.

What does it mean?

It is touch and go to see if the Fed can really stabilize growth & inflation expectations and it will take weeks to figure it out, very likely needing another 75bp rate hike at the next meeting. This is a reminder that in such a complex environment, diversification across styles found in some flexible solutions can help to wait out the next investment phase when we see greater clarity. That should come when inflation expectations come down worldwide supporting fixed income (e.g. investment grade) and eventually equities once leading indicators rebound – a classical result of asset allocation.

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