The Federal Reserve has a dual mandate; full employment and price stability—which, if you think about it, is a tricky thing to solve for. If everyone who wants a job has a job, there is likely to be ample demand for labor, pushing up wages specifically and inflation broadly. At the same time, if prices are flat to only marginally higher, it is likely economic growth is modest and many folks who want to work can’t find work.
While the Fed has a dual mandate, it emphasized getting the labor market back to full strength as we came through the worst of the pandemic, putting in place a historically supportive policy construct (rates at zero, $120 billion a month in securities purchased). That move likely helped push our unemployment rate back below 4% but also likely helped create today’s high inflation. Comfortable that the labor market is at, or close to full employment, and concerned that high inflation might become entrenched, the Fed is pivoting to a more restrictive policy construct (the securities purchase program wound down by March, rates likely moving higher in March and balance sheet reduction likely commencing this year). While we think the Fed’s pivot is justified, it has unnerved Wall Street as investors want the Fed to tame inflation but worry that effort will bring the economic expansion to an end (higher rates have historically been the catalyst for recessions as the cost of capital becomes more expensive and investment and spending slow).
How will we know if the Fed can tame inflation without upending the economy? Many of us will be paying attention to the US Yield Curve, particularly the spread between the yield on the US 2 Year Note and the yield on the US 10 Year Note. When the yield of the latter is above the yield of the former, it’s usually an indicator of a healthy economy, but if the yield of the latter is below the yield of the former – or the curve is inverted – it’s usually an indicator of a coming recession. While the spread between the yield on the US 2 Year Note and the yield on the US 10 Year Note has narrowed, it remains positive, and the curve remains positively sloped (see chart). We remain hopeful the Fed will be able to rein in inflation in 2022 without putting the economy into a recession.