By: Russ Kamp, Managing Director, Ryan ALM, Inc.
Given our current economic environment, are investors acting prematurely that the US Federal Reserve has actually accomplished its objective of thwarting inflation? We believe so. As the graph below depicts, market participants have been driving longer-dated Treasury yields lower with each subsequent move up in the Fed Funds Rate anticipating that our economy will slow, and rates will need to fall as a result. In fact, this belief is so strong as to have longer-maturity 10- and 30-year Treasuries trading at yields lower than they were on May 1st.
As we wrote in Tuesday’s post, Can Inflation Be Contained at an FFR of 2.25%?, in February 1982 when we last had an annual inflation rate in excess of 8%, the Fed Funds Rate was at 14.8% and the 10-year Treasury was yielding 14.0%. Given that it took the Fed elevating the FFR to 6.8% above the prevailing inflation rate during that month, why would anyone believe that our current FFR of ONLY 2.25%, a full 6% below the CPI-U, would constrain inflation? Yet, every time the Fed raises the discount rate, long bond yields fall. Does this action seem premature to you?
It will be interesting to witness the reaction in September to the Fed’s next move. Will we see a similar pattern to recent activity in which an increase in the FFR immediately drives longer-dated bond yields lower or will investors realize that the Fed is going to have to do much more to finally tamp down economic activity and inflation? I certainly don’t want to see the FFR at >10%, but unless inflation comes down quickly, and today’s retail sales # (0.7% X gas and autos) certainly doesn’t support the premise that our economy is slipping into recession, we will likely see the Fed remain aggressive in pursuit of their primary objective… an inflation rate approaching 2% and positive real rates. We are far from those metrics today!