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Investors familiar with Emerging Markets know that in a wage inflation spiral, the central bank must maintain a tight monetary policy by having real interest rates that are sufficiently positive (5Y inflation is a tad above the 5Y sovereign, see Graph below). This also helps avoid imported inflation from a weaker currency. Beyond this is unknown, as the Federal Reserve has no econometric model able to forecast the complex impact of a wage inflation spiral. To regain its credibility, the Fed must therefore 1. Aim for positive real interest rates 2. Avoid wasting time learning by doing 3. Regain control of the narrative which shapes our expectations.
1. Real interest rates need to be positive
The Federal Reserve needs to bring the terminal rate or long-term interest rates into positive territory as fast as possible. The reason is to avoid an uncontrolled spread of the wage inflation spiral, caution means overdoing it and we are not there yet. The cost of failing is a recession as real rates are brought to very high levels as Paul Volcker did in the early 1980s. With inflation at 7.9%, there is plenty of room for long-term interest rates to increase – though some of that inflation will naturally fade with improvements in the supply chain.
2. Avoid wasting time by learning by doing
It normally takes six to eighteen months for monetary policy to have an impact on the economy. With an economy running hot, it is likely to take longer. This is a very long time for the Fed to decide whether it wants to go ahead of the curve and not run behind inflation as some EM central banks do (e.g. Brazil). That is also a long period of time for investor expectation to have significant swings.
3. Controlling the narrative
In a system that is fundamentally unstable, we know that good control of the narrative can have a powerful effect by shaping the new equilibrium and inflation expectations. The Fed is already trying to wrestle this control from the market, but to become dominant, it will probably need to turn far more hawkish, something the White House may not be ready for ahead of the midterm elections.
We remain prudent on US equities especially the Growth style, given potential shocks from liquidity being retrieved at a rate faster than expected. The equity market is likely too optimistic regarding growth prospects with the fixed income market more realistic. In fixed income, the opportunity set is wide with the potential for eventually a far more hawkish Fed.