The Fed’s Soft Landing - 07.06.23

As we’ve heard Powell emphasize, the Fed has a primary objective of both maximum employment and price stability. We’ve seen one of these become unhinged over the past 24 months, that being inflation. However, inflation is slowly cooling and there are signs that the Fed has put monetary policy into restrictive territory.

Due to the fact the entire Fed mandate is basically cemented around the Phillips Curve, they are forced to display some sort of recognition that reducing inflation requires a correction in employment. (The Phillips Curve represents an inverse relationship between employment and inflation). It’s well known that there is a considerable lag between correlation of the two and unemployment can pick up well after inflation has returned to normal territory.

The problem is, the soft landing completely negates this academic theory. The soft landing claims that inflation can repair itself without the need to damage employment. We know that this is impossible in the long run, but it’s likely we’ll see the illusion of its success.

We’ve been saying that it’s impossible all year long, but it really comes down to where you put your goalposts of observation. For example, inflation is well off highs. It can continue lower, although we may see some chop and employment could remain stable. This would be a “soft landing”. But what happens if employment lags inflation by 12-24 months for whatever reason? Then would you negate the realized soft landing…? No, most likely everyone would classify it as successful. But everything’s connected and to claim you saved inflation without restricting the economy would be a bold historical moment.

So why are rates up? Inflation is on the way down…what’s going on?

Due to the focus on the soft landing, everyone has their eyes on employment. They’re thinking the Fed will not alter their policy path of incrementally higher rates until employment numbers abate. This is where the problem lies. The more inflation returns to target, although we believe the employment situation to be under a considerable lag, it will look more and more like the soft landing is achieved. More importantly, it will look more and more like the Fed has returned to LOWER inflation and MAXIMUM employment.

We’re seeing yields lift on the preface that the Fed will be more restrictive due to a hotter-than-anticipated labor market. Yes, not because inflation is accelerating, but because jobs remain strong. If you really think about it, as long as inflation trends lower, with some interim chop, why would employment be an issue for the Fed? They themselves would realize they’ve achieved the “impossible soft landing”.

We think that the Fed is very capable of making policy errors, specifically in the fashion of over and under-tightening. I do think we’re rather restrictive at the moment, the most in over a decade compared to breakevens.

We’ve heard Powell reference our beloved “real yields”, specifically stating that reals can expand without the Fed actually hiking more. What he means by this is real yields, which are calculated via (nominals-breakevens) can go up if nominal stay relatively flat while breakevens continue to weaken). This is one factor of the many that are associated with the Fed’s policy lags. We’ve already seen breakevens come down nicely since the mid ‘22 highs. Now it’s all bout if we can anchor here or breakout higher/lower.

The way to approach the current situation is to look at the forward rate market + factors and ask yourself this. If the purpose of rate hikes is to slow inflation, inflation is currently slowing, why would anything other than a pause be necessary? We think the policy mistake won’t be in the form of additional hikes, but rather holding rates for longer than required at current levels. The Fed can certainly make TWO policy mistakes…LOL, but you get the point. Obviously, if breakevens start breaking out, this would be a signal the Fed needs to do more as the market sees further inflation risks. We’re not there just yet.