The Federal Reserve’s (Fed’s) primary goals are to promote maximum employment and stable inflation. But as the Fed gets set to revisit this mandate at the September 19-20 Federal Open Market Committee meeting, employment and inflation remain at odds.
Labor Market Stronger, Inflation Weaker
On the one hand, the U.S. labor market continues to improve. The July unemployment rate of 4.3 percent matched a 16-year low and remained well below the 5 percent rate the Fed generally considers reflective of “full employment.” On the other hand, inflation has been stubbornly weak and far short of the Fed’s 2 percent target. The core Personal Consumption Expenditures Index (PCE), the Fed’s preferred inflation guage which excludes volatile food and energy prices, increased only 1.5 percent year-over-year in June. Headline PCE, which includes food and energy prices, increased 1.4 percent. Core PCE has been below the Fed’s target for more than five years.
It’s been the Fed’s contention that an improving labor market eventually will drive up inflation. The central bank argues that inflation weakness is “transitory,” and labor market gains eventually will spark wage growth that will boost demand for goods and services, fuel stronger economic growth, and help push inflation higher.
So far, such a scenario hasn’t played out, creating a conundrum for the Fed’s rate normalization plans—and a likely continuation of the range-bound interest rate environment for bond investors. Earlier this year, the Fed expected to make three rate hikes this year; so far, it’s made two.
Rate Hike Likely on Hold
Minutes from the Fed’s July policy meeting indicate the central bank is becoming increasingly concerned about inflation trends. Some FOMC members called for a rate hike halt until it’s clear the current inflation trend is indeed transitory. Others worried additional rate-hike delays might eventually lead to rapidly growing inflation that would be difficult to control and costly to reverse. Ultimately, the July vote to hold rates steady was unanimous.
As of mid-August, it appears the “rate hike halt” faction may prevail once again. The financial markets have priced in virtually no chance of a rate increase at the Fed’s September meeting and a less-than-50% chance the Fed would tighten again before year-end. We think the weaker inflation data may prompt the Fed to push additional rate hikes into 2018.
Balance Sheet Moves to Forefront of Fed Policy
With rate hikes on hold, we expect the Fed to turn its attention to “normalizing” its record-high $4.5 trillion balance sheet (its portfolio of Treasuries and mortgage-backed securities, or MBS). The Fed outlined a potential strategy for gradually reducing its balance sheet following the June FOMC meeting, but policymakers deferred the timeline until an upcoming meeting. We believe the Fed will announce a start date at the September FOMC meeting.
In the aftermath of the financial crisis, the central bank purchased Treasuries and MBS in a six-year effort to boost lending and support the financial markets (the program known as quantitative easing, or QE). This bond buying added $3.7 trillion to the Fed’s balance sheet. Although the Fed ended QE in 2014, it continues to reinvest all principal payments from its holdings back into the Treasury and MBS markets. This activity has provided continued support for the bond market—support that if ended abruptly potentially could drive interest rates sharply higher and derail economic growth.
Slow, Steady Approach Should Reassure Market
However, we believe the Fed will pursue balance sheet normalization the same way it’s seeking interest rate normalization—slowly, gradually, and transparently. This steady approach in an environment of modest economic growth and weak inflation—and healthy demand for Treasuries—should limit any significant bond market disruptions. Although the MBS sector may be vulnerable to some modest yield pressures as the Fed tapers its reinvestment activity, we do not expect a significant spike in yields.
Short-maturity interest rates are directly influenced by Fed actions, but longer-maturity rates and yields are more market driven. Supply and demand for bonds, geopolitical factors, and expectations for inflation and economic growth are key influences on longer-maturity rates.
Market conditions have kept longer-maturity U.S. Treasury yields in a tight range so far this year, as investor expectations for stronger growth, a boost in infrastructure spending, and higher inflation have moderated due to political gridlock in Washington, D.C. Investors initially expected President Trump’s pro-growth policies would usher in stronger growth and higher inflation in 2017. But much of the president’s agenda remains stalled, which is helping to hold down longer-maturity rates. In addition, the rate divergence among developed markets continues to prevent a break out to significantly higher rates in the U.S.
Given this backdrop, we expect the 10-year Treasury yield to remain in a range of 2 percent to 2.60 percent for the next 12 months, barring any big surprises in U.S. or global economic conditions.
Generally, as interest rates rise, bond values will decline. The opposite is true when interest rates decline.
The opinions expressed are those of Dave MacEwen and are no guarantee of the future performance of any American Century Investments portfolio.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.