A hot topic in the bond markets nowadays is the prospect of America’s central bank, the Federal Reserve, raising its policy target sometime later this year (colloquially referred to as “raising interest rates”). Counterintuitively, since the U.S. economy is doing “somewhat” well (to use the Fed’s terminology), this may be exactly the wrong action to take. The Economist newspaper last week dedicated one of its attention-getting “Leader” articles to the topic of lessening the sting of the next recession. In the article titled “Watch Out,” the authors mention that economic recoveries rarely extend longer than a decade, and caution that America’s began six years ago. The conventional thinking is that policymakers like the Federal Reserve need munitions in store to combat the next economic downturn. Therefore, it makes sense to raise interest rates soon so they can be lowered in the future when necessary. Raising interest rates now obviously increases borrowing costs and intentionally decreases spending activity. The latter is troubling. If America is currently struggling to generate sufficient inflation, why make it even more difficult by increasing costs? The authors propose the counter: wait until wage growth picks up and inflation hits its two-percent target before taking any action. Temporarily heightened inflation is a much smaller concern than plunging into recession, the thinking goes. Our portfolio positioning reflects a low trajectory for inflation in the coming years, and if the Fed takes action sooner rather than later, we will likely revise our forecast downward. For now, we are looking for signs inflation might shoot up suddenly, forcing a quick response from the Fed. But until we see concrete evidence, we are holding tight.
Source: Economist, Federal Reserve, SNWAM Research