What Happens After the Fed Sticks the Landing?
If an assassination attempt ultimately leaves markets mostly steady and the pandemic shock is now gone, what challenges lurk ahead for our intrepid central bankers?
Another U.S. assassination attempt shocks the conscience, but seems unlikely to shift America’s political divisions or economic outlook for now. Last week’s U.S. consumer price data have markets ever more convinced that the Federal Reserve will defeat inflation without a serious recession. Finally, after a pandemic shutdown, a massive fiscal stimulus and one of the steepest rate-hiking cycles in history, the Fed’s 2% target looks reachable without throwing a lot of people out of work.
For all the abuse they suffered for “letting” inflation spike to 9.1% just two years ago, the members of the Federal Open Markets Committee are about to stick the landing. As American voters sort through their preferences for two deeply unpopular candidates and tenuous political coalitions, the Fed will be taking stock of the next choices it may soon have to make.
If anything, the monetary challenges ahead look even more complex than bringing massive supply and demand shocks in line. The challenge also looks very different from recent decades when an expanding global labor market and savings glut drove price pressures ever lower. It’s a sure bet that future interest rates will be more volatile and it’s a likely bet the range will be higher, too.
A recession may yet sneak up despite robust data on jobs, consumption and corporate profits. The yield curve remains inverted and high prices are dampening demand for Cheetos. Alternatively, the recent easing in financial conditions could trigger a fresh bout of inflation, forcing the Fed to consider unexpected rate hikes. So could another container ship stuck in the Suez Canal. More likely than not, however, the Fed can take a victory lap even as it scans for the next likely shocks to the approaching balance of stable prices and full employment.
Topping this list is the U.S. fiscal path as the Congressional Budget Office projects that debt held by the public will rise from 99% to 122% of GDP over the next decade. It will almost certainly be higher as neither Republicans nor Democrats want all the 2017 tax cuts to expire any more than they want to advance significant spending cuts. All else equal, lax fiscal discipline will likely force the Fed to lean against inflationary pressures far more than it did before COVID.
But if, over time, investors demand a premium for America’s rising political risk or deteriorating debt dynamics, the headwinds from higher long-term rates could force the Fed to cut at the short end. U.S. Treasury markets traditionally benefit from higher uncertainty, but would they remain a safe haven if the presidential election requires court intervention to choose a winner? What if a president redefines the country’s business model by restricting key imports and expelling recent immigrants? What if he renounces the debt incurred under “corrupt” predecessors?
If America’s fiscal path somehow stays on the rails, rising trade will deliver its own jolt. Again, the more likely push is inflationary as tariffs rise and companies pay a premium for supply chains that seem slightly more protected from China risk. If back in office, Donald Trump might use his threats of 10% tariffs across the board (and 60% on Chinese goods) only as negotiating leverage, but the costs of international trade are rising under any election scenario.
Against pressures that will run the economy hotter than before, the Fed will need to monitor risks of another burst pipe in the world’s financial plumbing. We appear to have weathered recent rate hikes with little more than a few stomach-churning moments for the U.K. pension market and a handful of regional U.S. banks. (Oh, and Credit Suisse….) But worries persist about the expanding flows into private markets that regulators cannot see.
In principle, investors in these unlisted assets like private credit and real estate are less levered and more patient than their public market peers, but you never really know who is exposed to whom until there’s a sudden loss to absorb. Generally, it’s a good rule of thumb to start worrying about financial risks when regulators start easing capital rules.
As investors wrestle with the promise of artificial intelligence, the Fed will be sorting out fiendishly difficult price dynamics from these innovations. Massive new investments in data centers, for example, will boost demand and drive up prices, even if increased productivity helps moderate inflationary pressures. Meanwhile, much AI innovation looks deflationary if it eliminates white-collar administrative jobs faster than it creates more productive new roles.
It’s a sure bet that future interest rates will be more volatile and it’s a likely bet the range will be higher, too.
The effects of climate change on prices will also be difficult to untangle. Government investment in clean energy infrastructure and emissions regulations will push prices higher, but expanding solar and wind generation will bring energy costs down. Already, more intense weather patterns are raising property insurance costs for businesses and homeowners, but in time there will be stranded hydrocarbon assets that have a lasting deflationary effect.
Yes, in retrospect, the Fed should have started hiking sooner than 2022 as inflation proved less “transitory,” but the “soft landing” coming into view now still looks remarkable and worthy of the current market celebration (cue National Anthems for the medal ceremony).
The price pressures gathering in the distance, however, look more ominous and confusing for our intrepid central bankers. As voters weather a presidential campaign that has already brought shocking twists, investors should brace for monetary gymnastics with much higher levels of difficulty.