skip navigation

Stay up to date on timely topics and market events. Subscribe to our Blog now.

15 June 2022
June FOMC Meeting—Risks to Fed Policy Likely More Balanced Going Forward
By John L. Bellows, PhD

Stay up to date on timely topics and market events. Subscribe to our Blog now.

Today the Federal Reserve (Fed) raised interest rates by 0.75%, a larger move than at the May Federal Open Market Committee (FOMC) meeting and larger than was widely expected just a few days ago. The rate increase was accompanied by forceful statements about Fed officials’ commitment to lower inflation.

The catalyst for the larger rate hike appears to have been the upside surprise in last week’s inflation report. Prior to that report, Fed officials had been uniformly supportive of a 0.5% hike, which was in line with the guidance Fed Chair Powell provided at the May press conference. Powell’s previous guidance, which admittedly was not strong enough to be included in the official post-meeting statement, appears to have been overwhelmed by a desire to appear vigilant with regard to inflation.

The risks to Fed policy are likely to be more balanced going forward
The abrupt change in the Fed’s plans for this week represents yet another hawkish surprise, extending a string of such surprises that started last fall. It is not clear, however, how much longer the hawkish surprises will continue. Looking forward we expect the risks around Fed policy are likely to become more balanced, perhaps even tilting toward dovish risks as yields reach higher and higher levels. In particular, the foundations of more moderate inflation appear to be building, which may obviate the need for further hawkishness. At the same time, the downshifting growth outlook raises the possibility of a dovish adjustment at some point.

As the Fed attempts to navigate the risks on either side of its policy, it is trying again to provide guidance regarding its plans for further hikes. Today Chair Powell commented on the likelihood of either a 0.50% or 0.75% hike at the July meeting. Chair Powell also spent a considerable amount of time talking about the Fed’s expectations for the level of rates at the end of the year, which is also a form of guidance. Previous attempts at offering guidance have been overwhelmed by events, and it remains unclear whether this latest iteration will be any more effective. Nonetheless, it appears that the Fed will keep trying. The desire to control expectations is understandable. While higher interest rates may ostensibly work toward the Fed’s goal of slowing inflation, it’s less clear that extremely elevated volatility in interest rates is all that helpful.

Moderating inflation would obviate the need for further hawkish surprises
The higher-than-expected print in the Consumer Price Index (CPI) for May was the clear precursor to today’s rate hike. The new peak in headline inflation, combined with a slight reacceleration in core inflation, challenged the Fed’s expectation that inflation would be coming down by this time.

It’s important to note, however, that the most watched measures of inflation, particularly including the CPI, have a substantial backward-looking component. The shelter components of CPI, for example, reflect price changes that happened months ago. The more forward-looking indicators of inflation appear to be consistent with moderation, specifically:

  • Goods inflation, which was responsible for as much as half of core inflation in 2021, has moderated so far in 2022. There is scope for goods inflation to fall further, perhaps even for it to turn negative, should retailers offer discounts in order to address building inventories and softening demand.
  • Wage inflation has similarly moderated. Average hourly earnings increased at a 3.5% annualized rate in each of the last two monthly employment reports, continuing a downward trend in this series that has been in place since last fall. Should wage inflation remain at these levels—a likely outcome, given the ongoing recovery in the labor supply and some diminution in labor demand—that would in turn relieve some of the pressure on services inflation.
  • Finally, while house price and rent increases have remained high in the most recent reports, there are signs of slowing in housing as well. The sharp decline in new-home sales, together with much lower levels of applications for mortgages, suggests that the combination of high prices and elevated mortgage rates will weigh on further price increases.

All of these considerations were likely incorporated into the Fed’s forecast, which is why the changes today were only modest. The Fed increased its forecast for core inflation by just 0.2% in 2022 and 0.1% in 2023, in both cases much smaller increments than the changes made to the forecast in March.

In the beginning of the year the Fed’s hawkish surprises coincided with upward revisions in the inflation outlook. That had a certain logic to it: the Fed forecast that the inflation outlook was worse (higher) than before, and at the same time it acknowledged that higher inflation would require a more hawkish policy. The situation now is a bit different. Today’s hawkish Fed surprise did not coincide with a material revision in the forecast. To the contrary, the inflation outlook may be improving, on the margin, and accordingly the changes to the forecast were only modest. Should this trend continue—and in particular should the inflation data start to decline on a month-over-month basis—it would seem that there would be no more need for hawkish surprises.

The Fed is likely to pay more attention to growth going forward
While the inflation data has been the dominant factor influencing the Fed’s recent actions, it is not the only consideration that is relevant for the Fed. In fact, we expect that the Fed is likely to pay somewhat more attention to the growth side of its mandate in coming months. One reason for a shift toward growth is that demand is likely to continue decelerating. Current-quarter GDP growth is tracking below 1%, according to the Atlanta Federal Reserve, which would be the second quarter in a row of below-trend growth. Other indicators of demand have also moderated. Monthly job growth decelerated somewhat in May, monthly gains in real retail sales have moved materially below last year’s pace, and sentiment surveys have fallen significantly.

All of these likely contributed to the downgrade of growth in the forecast released at today’s meeting. The Fed now expects growth to be only 1.7% in 2022, which is below its own estimates of trend. Importantly, this is a substantial markdown from the forecast the Fed made three months ago, when the Fed expected growth to remain comfortably above trend.

Another reason that we expect the Fed to increasingly shift its attention to growth is that eventually the level of interest rates will start to bite. The impact of higher interest rates on economic activity varies by sector, and also varies according to differences in the economic environment. It’s likely that the current level of interest rates has already impacted the housing market. The most recent data suggests a sharp slowing in both home sales and also home construction, very likely related to the 200-bp rise in mortgage rates since the beginning of the year.

We believe as interest rates continue to increase other sectors will be similarly affected and the impact of higher rates will continue to accumulate across the economy in coming quarters. In our view, it seems that the Fed is still a bit optimistic with regard to its growth outlook, and the risks are certainly that the impact of higher rates drags growth further below trend for this year and next. Below-trend growth will, in turn, get the Fed’s attention, as inflation is unlikely to remain elevated for very long in such an environment.

The 0.75% hike at today’s Fed meeting was another hawkish surprise, making it just the latest in a string of hawkish surprises that started last November. This environment has been exceptionally challenging for fixed-income investors. All aspects of the bond market have been affected: Treasury yields have moved sharply higher at the same time as spreads on mortgages and corporate credit have moved wider.

Going forward we expect the risks around Fed policy to become more balanced. And as the risks around Fed policy become more balanced, so too should the market environment for fixed-income investors. Not only may the rise in Treasury yields abate, but lower volatility could also lead investors to reengage in fixed-income spread sectors, especially given current valuations. We anticipate that such an environment has the potential to be quite different than the one-sided risks that have been realized over the past few months.

© Western Asset Management Company, LLC 2024. The information contained in these materials ("the materials") is intended for the exclusive use of the designated recipient ("the recipient"). This information is proprietary and confidential and may contain commercially sensitive information, and may not be copied, reproduced or republished, in whole or in part, without the prior written consent of Western Asset Management Company ("Western Asset").
Past performance does not predict future returns. These materials should not be deemed to be a prediction or projection of future performance. These materials are intended for investment professionals including professional clients, eligible counterparties, and qualified investors only.
These materials have been produced for illustrative and informational purposes only. These materials contain Western Asset's opinions and beliefs as of the date designated on the materials; these views are subject to change and may not reflect real-time market developments and investment views.
Third party data may be used throughout the materials, and this data is believed to be accurate to the best of Western Asset's knowledge at the time of publication, but cannot be guaranteed. These materials may also contain strategy or product awards or rankings from independent third parties or industry publications which are based on unbiased quantitative and/or qualitative information determined independently by each third party or publication. In some cases, Western Asset may subscribe to these third party's standard industry services or publications. These standard subscriptions and services are available to all asset managers and do not influence rankings or awards in any way.
Investment strategies or products discussed herein may involve a high degree of risk, including the loss of some or all capital. Investments in any products or strategies described in these materials may be volatile, and investors should have the financial ability and willingness to accept such risks.
Unless otherwise noted, investment performance contained in these materials is reflective of a strategy composite. All other strategy data and information included in these materials reflects a representative portfolio which is an account in the composite that Western Asset believes most closely reflects the current portfolio management style of the strategy. Performance is not a consideration in the selection of the representative portfolio. The characteristics of the representative portfolio shown may differ from other accounts in the composite. Information regarding the representative portfolio and the other accounts in the composite are available upon request. Statements in these materials should not be considered investment advice. References, either general or specific, to securities and/or issuers in the materials are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendation to purchase or sell such securities. Employees and/or clients of Western Asset may have a position in the securities or issuers mentioned.
These materials are not intended to provide, and should not be relied on for, accounting, legal, tax, investment or other advice. The recipient should consult its own counsel, accountant, investment, tax, and any other advisers for this advice, including economic risks and merits, related to making an investment with Western Asset. The recipient is responsible for observing the applicable laws and regulations of their country of residence.
Founded in 1971, Western Asset Management Company is a global fixed-income investment manager with offices in Pasadena, New York, London, Singapore, Tokyo, Melbourne, São Paulo, Hong Kong, and Zürich. Western Asset is a wholly owned subsidiary of Franklin Resources, Inc. but operates autonomously. Western Asset is comprised of six legal entities across the globe, each with distinct regional registrations: Western Asset Management Company, LLC, a registered Investment Adviser with the Securities and Exchange Commission; Western Asset Management Company Distribuidora de Títulos e Valores Mobiliários Limitada is authorized and regulated by Comissão de Valores Mobiliários and Brazilian Central Bank; Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services License 303160; Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services License for fund management and regulated by the Monetary Authority of Singapore; Western Asset Management Company Ltd, a registered Financial Instruments Business Operator and regulated by the Financial Services Agency of Japan; and Western Asset Management Company Limited is authorised and regulated by the Financial Conduct Authority ("FCA") (FRN 145930). This communication is intended for distribution to Professional Clients only if deemed to be a financial promotion in the UK as defined by the FCA. This communication may also be intended for certain EEA countries where Western Asset has been granted permission to do so. For the current list of the approved EEA countries please contact Western Asset at +44 (0)20 7422 3000.