The Fed’s Hands-Off Approach to Inflation

Rising inflation and renewed concerns about long-term price stability have sparked fears that the Federal Reserve may once again be forced to raise interest rates. But we think this idea is wrong – at least for now.

The Fed is too slow most of the time…

In our opinion, the financial markets are already doing much of the Fed’s work. For example, Treasury yields have moved sharply higher following hotter-than-expected inflation data, which has tightened financial conditions across the economy in the last few weeks - even without direct action from the central bank. As a result, we think the Fed will be able to maintain current short-term interest rates through year-end while allowing the bond market itself to apply additional economic restraint. In other words, the bond market is doing what the Fed is afraid to do.  

Here’s why…

The Federal Reserve primarily controls short-term interest rates through the fed funds rate, but long-term borrowing costs are heavily influenced by the bond market. When investors anticipate persistent inflation, larger government deficits, or higher future rates, bond investors demand higher yields to hold long-term Treasury securities. That dynamic was visible, today, after the latest Consumer Price Index (CPI) report showed inflation accelerating faster than expected.

Treasury yields climbed following today’s report, pushing up borrowing costs throughout the economy. This slows the economy as mortgage rates, corporate bond yields, auto loans, and other forms of credit that move in the direction of bond rates continue to make things more expensive.

But that leads to another Fed problem… 

Higher inflation creates uncertainty for businesses. Companies facing rising labor costs, higher input prices, and uncertain consumer demand become more cautious about adding workers. This pressure is especially visible in interest-rate-sensitive industries such as housing, construction, finance, and manufacturing. Elevated mortgage rates, for example, can reduce home sales and development activity, leading to slower job growth across real estate and construction-related sectors.

Unfortunately, employment is a lagging economic indicator. Financial markets react immediately to inflation data, while hiring slowdowns and layoffs often appear months later. As a result, today’s CPI report does not necessarily signal an immediate deterioration in employment, but it does raise the probability of slower hiring, weaker wage growth, and a softer labor market later this year.

If inflation remains elevated while unemployment stays historically low, policymakers will be forced to keep interest rates restrictive for longer to prevent a wage-price spiral from developing. And the bond market knows this.  In our opinion, that’s why the Fed is perfectly content to ride out higher rates by the bond market, while watching that rates don’t rise too quickly or too high to materially impact the labor market.  For now, the Fed is a spectator – not an active participant. 

‍