When will the Fed pivot from its aggressive tightening? Co-Head of Investments Jeff Klingelhofer thinks the Fed’s little known “third mandate” provides insight.
Yes, the Fed has Three Mandates
The Federal Reserve is sometimes referred to as a “dual mandate” central bank, and for good reason. The Federal Open Market Committee, the committee responsible for setting the Fed’s monetary policy, makes decisions in pursuit of maximum employment and price stability. The FOMC is very explicit about this – in fact, it is directly referenced in each meeting statement they release after a policy rate decision. Despite referring to these two goals as the dual mandate, the Fed is actually tasked with three goals: maximum employment, stable prices, and moderate long-term interest rates. These goals are explicitly stated in the Federal Reserve Act. Therefore, it seems incorrect for the Fed to keep referring to its mandate as a dual one, not a “tri-mandate”. When we asked two Federal Reserve officials what this third mandate means, they said they didn’t know, but they view it as giving the FOMC the flexibility it needs to pursue its first two mandates.
The Fed’s Delicate Balancing Act Hinges on the Third Mandate
How has the Fed pursued this flexibility? It is well known that in the aftermath of the Global Financial Crisis, the Fed pursued an extremely accommodative monetary policy, in order to lower what was then the highest unemployment rates experienced in a generation, as well as to stave off disinflationary trends. Although the Fed didn’t explicitly state it, the injection of massive amounts of liquidity into the financial system had the benefit of stabilizing and boosting markets. Investors interpreted the Fed’s monetary policy actions and forward guidance as a method to dampen financial market volatility, raise asset prices, and create a wealth effect for the purpose of increasing consumer confidence and fostering growth. Financial market stability in effect became the Fed’s third mandate. Policy remained accommodative for essentially all of the 2010s (even though the Fed embarked on a modest hiking cycle in 2017-2018) and into the COVID pandemic. In fact, the Fed’s aggressive action in their quick return to the zero percent interest rates and expanded Fed buying programs showed how strongly the Fed believed in the importance of financial market stability to mitigate the effects of economic dislocations.
Interestingly, during this extraordinary period, Chairman Jerome Powell and others at the Fed began to change their perspective on the nature of the third mandate. The Fed started to tout the view that its role at that time was to ensure that the post-pandemic economic recovery was more inclusive, which meant decreasing the wage gap for those workers at moderate or lower wage income levels. To support this goal, Mr. Powell announced at the 2020 Jackson Hole Economic Symposium that the Fed would adapt “average inflation targeting”. That is, the FOMC would now tolerate core inflation modestly above 2%, so long as inflation averaged 2% over the longer run. The primary effect of this change, from a monetary policy perspective, was to keep policy more accommodative in support of the maximum employment side of the Fed’s mandate. At the time when Chairman Powell announced this shift, the Fed likely believed that inflation was going to stay structurally low, and that the FOMC needed to see inflation actually rise before raising policy rates. In hindsight, this game of chicken ended badly for the Fed, as it is engaging in aggressively tight monetary policy very few could have envisioned when the Fed transitioned to average inflation targeting.
Sniffing Out a Fed Pivot?
Fast forward to the present. We believe the shift in the third mandate from one of financial market stability to one of socioeconomic stability will provide potential clues on how the Fed will chart its course towards an eventual interest rate pivot down the line. It’s important to first note that we believe the Fed’s inflation battle has a long way to go, and that investors should not read too much – yet – into what has been more favorable Consumer Price Index reports. In order for the Fed to step off the brakes, inflation will have to come down much further. How much so will somewhat hinge on the Fed’s view as to the amount of what the Fed could deem “good” vs. “bad” inflation exists in the economy. This is where we believe the third mandate comes into play.
“Good” inflation — that is, the type that the Fed could have a higher tolerance for — is services or wage inflation, especially among lower-income earners. This kind of inflation can help compress the wage gap, which for the Fed is a desirable outcome that leads to more socioeconomic stability. “Bad” inflation, on the other hand, is driven by a continued above trend rise in prices of goods that eats away at everyone’s paychecks, and worse, disproportionally hurts low-income earners. Bad inflation then has the potential to obstruct the achievement of all three Fed mandates.
Since Peaking in July, Overall and “Bad” Inflation Has Receded, but Not Enough for the Fed to Pivot – Yet.Source: Bloomberg. Data as of December 31, 2022
Given that the new importance assigned to socioeconomic stability has become an important third actor in the balancing act of maximizing employment and providing stable prices, we believe the central bank will likely tolerate overshooting the 2% inflation target by an acceptable amount, such as 3% to 3.5%, so long as it arises from so-called good inflation. In other words, before an eventual pivot, the Fed will need to see goods inflation decrease at a faster pace than low-income wage inflation, even though it wants both types to come down significantly more than what we have seen thus far.
The implication of all this is that demand destruction is likely necessary for reducing inflation to a more sustainable level — but, for the Fed, it matters where that demand destruction occurs and whom it impacts. The Fed is clearly attempting to reclaim price stability without significantly harming the labor market, with particular concern not to disproportionately harm low-wage workers in the process.
Conclusion: Life after the Pivot
Looking ahead, and despite the fragile state of the economy, our baseline expectation is that the Fed will not significantly change its policy stance in the near term. In order for it to pivot and start cutting rates, the Fed will need to see proof of demand destruction — in other words, a recession, and hopefully a mild one. This time, though, the Fed may not be fighting the disinflationary demons that have haunted them for the decade after the Global Financial Crisis. Though easing may be necessary, we may enter a new normal that appears quite similar to the old one we once knew: a moderate level of interest rates and inflation trending closer to a 3% to 4% range.
In particular, we believe the time has come for the old 60/40 portfolio to shine once again because high-quality, short-duration assets are offering attractive risk-adjusted yields compared to their longer duration counterparts (see table below). Investors looking for income, and protection from rate volatility, may want to consider pivoting toward short-duration investments while the Fed’s pivot plays itself out. Investment grade corporate bond yields are above 5%, while low duration, well protected tranches in securitized credit yield in the upper single digits. Importantly, given the uncertainty of central bank policy going forward, it’s important for any individual fixed income strategy or program to stay flexible given what we believe are going to be shifting and evolving opportunities. In an era of more normalized Fed policy, Fed pivot or not, there should be a healthy – indeed, welcome level of differentiation – which fixed income investors should be ready to exploit moving ahead.
Short-Duration Assets Are at Similar or Better Yields than Long-Duration Counterparts
|Fixed Income Assets:
Short vs. Longer Duration Counterparts
|Yield to Worst|
|Bloomberg U.S. Government 1-3 Yr||4.50|
|Bloomberg U.S. Government 5-10 Yr||3.92|
|Bloomberg Municipal Bond: Muni Short 1-5 Yr||2.94|
|Bloomberg Municipal Bond: Muni Intermediate 5-10 Yr||3.11|
|Investment Grade Corporate|
|Bloomberg U.S. Corporate 1-3 Yr||5.25|
|Bloomberg U.S. Corporate 5-10 Yr||5.44|
|Bloomberg U.S. High Yield Ba to B 1-5 Yr||8.28|
|Bloomberg Ba to B U.S. High Yield||8.09|
|Emerging Markets (USD)|
|Bloomberg EM USD Aggregate: 1-5 Yr||7.69|
|Bloomberg EM USD Aggregate: 7-10 Yr||7.45|
So, putting it all together, while higher rates have undoubtedly caused pain for many investors, we believe there will be a bright spot in this “old-new” normal: interesting opportunities in fixed income. The absence of the Fed ‘put’ has brought more volatility and uncertainty, but valuations, as measured by yields and spreads, are more attractive to investors and provide return potential that didn’t exist for much of the 2010s.