Are Policymakers Being Too Patient on Inflation Risk?

The Federal Reserve last week made its highly anticipated announcement on “tapering” its asset purchases, the first step in pulling back on the unprecedented support it provided markets and the economy early in the pandemic. Later this month, the Fed will begin reducing its $120 billion-per-month asset-buying program by $15 billion a month. 

In his announcement, Fed Chair Jerome Powell largely kept to the script, hitting consensus expectations spot-on regarding the pace of tapering. Powell also acknowledged that the risk of inflation may not be as transitory as the Fed had anticipated earlier this year. But he left interest rate hikes for another day, stressing patience as well as a need for the job market to get back to “maximum employment” before any hikes took place. Stocks rallied to yet more new highs in response to the broadly dovish communique.

Although the Fed is working with some uncertainty around policy choices, we are concerned that the Fed's emphasis on patience remains disconnected from actual economic data, which could possibly result in policymaking that’s late in raising rates to tame inflation. Consider the following points: 

• Unprecedented divergence between interest rates and inflation: The gap between the fed funds rate—the target interest rate set by the Federal Open Market Committee—and the Consumer Price Index is now at the widest in the 60-year history of the inflation gauge, as rates remain low and inflation high. The implication here is a level of negative real rates that could fuel asset bubbles and misallocation of capital.

• Inflation worries among consumers and businesses: Policymakers seem to believe that inflation is primarily driven by supply-chain issues and thus unlikely to be long-lasting. But inflation concerns seem implacable and are turning up in various corners, such as weakening consumer confidence, a moderation in CFO optimism and readings of inflation-linked anxiety in the recent election outcomes.

• Persistent wage pressures in the labor market: Today’s mixed job-market dynamics may complicate the Fed’s search for its definition of “maximum employment,” something it has said was a prerequisite for any interest rate increase. To be sure, the U.S. labor market looks to be healing—it just added an above-consensus 531,000 new jobs in October and saw the unemployment rate inch lower. But companies across sectors are experiencing labor-market tightness characterized in large part by surging wages, as reflected in the latest Employment Cost Index readings. Our analysis continues to suggest a shifting labor force, where lower participation rates may reflect structural changes that could keep competition for workers and wage pressures high.
  

With all this churning in the markets and economy, our parallel concern is that equities, and especially the passive S&P 500 Index, are increasingly anchored to interest rates that are expected to be “lower for longer.” We believe stock valuations are largely stretched in today’s environment, one that demands a diligent and active approach to risk management.

Investors should monitor labor market data, valuations on 2022 forward earnings and measures of market sentiment such as the Fear and Greed Index. In the meantime, investors should anticipate a pullback in passive stock indices and consider using the opportunity to reload equity portfolios in cyclical sectors, which stand to benefit in the next couple of years from the Fed running the economy hotter.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Nov 8, 2021, “When Doves Cry.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.