Is the Federal Reserve heading into an era of hawkish monetary policy?

Is the Federal Reserve heading into an era of hawkish monetary policy?
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The transition from Janet YellenJanet Louise YellenThink of this economy as an elderly friend: Old age means coming death On The Money: Rising recession fears pose risk for Trump | Stocks suffer worst losses of 2019 | Trump blames 'clueless' Fed for economic worries Recession fears surge as stock markets plunge MORE to Jerome Powell as chairman of the U.S. Federal Reserve is happening at an interesting moment for global financial markets and the U.S. economy. Yellen steadfastly argued that the U.S. labor market was not tight. Focusing on subdued wage growth and broader measures of participation and employment, she pushed back on the view that the U.S. economy was near full employment.

The implication of Yellen’s view was that more job gains were not only possible, but desirable. Initially, this was out of the consensus and met resistance from policymakers across the spectrum, but nevertheless it became the foundation for her policy of gradual and cautious rate hikes. In the event, Yellen was proven correct, perhaps beyond her own expectations. During her tenure as Fed chairman, the unemployment rate fell from 6.7 percent to 4.1 percent, and overall employment rose by 10 million workers, all without noticeable strain on the economy.

Yet in her final press conference, Yellen’s tone was far from victorious. She emphasized that the Fed consistently fell short of its mandate of 2 percent inflation. Indeed, year-over-year personal consumption expenditure inflation, which is the Fed’s preferred measure, did not touch 2 percent at any time while Yellen was Fed chairman, much less move symmetrically around the objective.

Yellen expressed concern that low inflation may be “ingrained.” It’s not just that missing the target undermines Fed credibility. Yellen’s emphasis on inflation reflects a deeper issue: Low inflation could be symptomatic of remaining slack in the U.S. economy, meaning policymakers may have yet more room to pursue employment growth.

As Powell prepares for his first meeting as Fed chairman later next month, many are wondering how monetary policy will look under the new leadership. There are two general observations. First, Yellen’s influence on Powell is unmistakable. In his confirmation hearing, Powell echoed the same themes of slack in the labor market that Yellen has emphasized.

Second, policy under Powell is likely to display a fair amount of inertia. Fed officials are generally reluctant to make sharp changes to the path of rates. Markets and data can be volatile, and the Fed is wary of adding unnecessarily to the uncertainty. Powell’s background as a Republican is another reason to expect inertia in policy. Republicans tend to be suspicious of active and dynamic monetary policy, instead favoring a consistent and predictable path for interest rates.

The Fed transition has been the backdrop, while economic data has recently been the main event. A recent uptick in inflation has many believing that an era of tight labor markets and hawkish Fed policy is around the corner. I am not convinced. Wage inflation remains below “normal” levels and there are many workers still on the sidelines. Even if wage inflation were to increase, much of that could be absorbed by corporate profit margins, leaving prices unchanged. More broadly, the long-term dynamics of high debt levels and an aging population work against inflation moving much higher.

Due in large part to expectations for higher inflation, there has been a sharp repricing of market expectations for Fed hikes. The market shifted from two hikes priced for this year to more than three hikes fully priced. The repricing has been even more striking further out the curve. For the first time in a number of years, the market is now priced above the Fed’s own estimates in terms of where interest rates will end up.

This pricing reflects substantial optimism that nascent wage inflation will not only be sustained but will also lead to overall inflation, that the positive momentum behind U.S. and global growth will continue uninterrupted for the foreseeable future, and that long-term growth and inflation trends are just as likely to exceed the Fed’s expectations as to come in under them.

Such optimism priced into markets warrants caution, and from these high levels we suspect that risks are likely to the downside. Concerns about “ingrained” low inflation, combined with an expected inertial approach from Powell, are unlikely to be the backdrop for a sharp adjustment steeper in the path of interest rates.

John Bellows, Ph.D., is a portfolio manager and research analyst at Western Asset Management, an affiliate of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.