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The Fed’s costly final mile

Published on 11-16-2023

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Recession likely to be harsher than expected


In shipping, the “final mile” refers to the end delivery point. In climbing, it refers to the most arduous ascent to the peak. No matter the context, the final mile is the culmination of a worthy endeavor.

In the context of fighting inflation, the “final mile” represents the successful and sustainable achievement of a central bank’s inflation target. For the Federal Reserve (Fed), which began tightening monetary policy in 2022 when core personal consumption expenditures index inflation peaked at 5.8%, the final mile represents the challenge of bringing it down from its current rate of 3.7% to its 2% target.

As worthy as the objective is, the final mile can come at significant cost. At altitude, oxygen is depleted and muscles ache. In transportation, goods must be offloaded from larger to smaller trucks at considerable cost.

Is the same true for monetary policy? Is the final mile the costliest part of restoring price stability?

According to Fed Chairman Jerome Powell, the answer is most likely “yes.” If that is true, are markets prepared for the hardship? Based on current pricing in stocks, bonds and currencies, the answer is “probably not.”

How the Fed sees the final mile

Perhaps the biggest surprise in macroeconomics this year has been the resilience of the U.S. economy and its labor market following aggressive Fed tightening since early 2022. Despite dire warnings from most economists, supported by classic “leading indicators” of recession – such as an inverted yield curve – the U.S. economy has motored ahead. If anything, over the past two years, growth has exceeded its trend. Job gains have exceeded the growth of the labor force,1 resulting in five-decade low unemployment rates.

Falling inflation across all measures (core, headline, consumer prices, and wages) has accompanied strong growth and a tight labor market. So why must the final mile – the achievement of the Fed’s 2% inflation target – be painful?

That is an important question. The Fed’s consistent message over the past year has been that a fall in inflation to its target will require a period of below-trend growth. Put differently, the Fed believes that for inflation to sustainably complete its desired decline, some slack must emerge across the economy, and particularly in the labor market.

That notion hinges on an apparent empirical regularity first published in 1958 by the New Zealand economist William Phillips. The eponymous “Phillips Curve” purports to show a trade-off between inflation and the rate of unemployment. Specifically, inflation is high and rising when unemployment is very low, and inflation typically declines when unemployment is elevated.

The Fed’s Phillips fascination

Powell has clearly stated that some slack in the economy will probably be needed to achieve lasting low inflation. In his recent remarks before the Economic Club of New York, Chairman Powell noted: “...the record suggests that a sustainable return to our 2 percent inflation goal is likely to require a period of below-trend growth and some further softening in labor market conditions.”2

There are, however, at least two odd aspects to that statement. First, as indicated in Exhibit 1 below, no statistically meaningful relationship exists between U.S. inflation and the unemployment rate over the past 65 years. That is true even when adjusting for lags between unemployment and inflation, or when using the gap between realized unemployment and its estimated equilibrium rate.

Second, as noted above, Powell's statement seemingly dismisses the fact that U.S. measures of core and headline inflation, as well as wage inflation, have all declined sharply over the past 12 months without a period of significant below-trend growth, much less a significant increase in unemployment.

So why is the Fed insistent that sustainably achieving its 2% inflation target will require below-trend growth and rising unemployment?

Several factors likely enter the Fed’s thinking.

Implications for markets

In sum, the Fed appears determined to maintain sufficiently restrictive monetary and financial conditions until economic growth slows below its trend rate and unemployment rises. Moreover, if those outcomes do not emerge soon, the Fed appears prepared to hike rates even further.

Are these outcomes consistent with current market expectations?

With respect to U.S. and global equities, the Fed’s baseline scenario presents a challenge to prevailing earnings expectations. The consensus of company analysts has boosted its S&P 500 profits forecast for 2024 to 11.9% growth.3 Should a growth slump below trend happen next year, earnings will likely turn out to be closer to flat, at best. If the economy dips into recession, earnings could fall outright.

Recently, U.S. bond yields have tumbled. But they remain a full percentage point above their levels from earlier this year, boosted by growth surprises and heavy Treasury issuance. If U.S. economic growth stumbles in the coming quarters, bond yields are likely to fall even further.

Finally, in 2023 the U.S. dollar has appreciated strongly, supported by higher U.S. bond yields and wider interest differentials relative to other countries. Those twin sources of support will recede if the Fed gets its way, likely leading to a weaker dollar in 2024.

In sum, investors risk underestimating the resolve of the Fed to engineer below-trend economic growth and rising unemployment to achieve its inflation target. A harsher-than-expected recession is likely. As a result, U.S. equity markets and the dollar appear vulnerable. The first five years of the U.S. Treasury curve remain too optimistic about Fed easing; in our view, rate cuts will probably occur later and more gradually than is currently priced into the market. We believe the longer end of the yield curve (10 years and beyond), which is more sensitive to the long-term growth, inflation, and financial implications of extended Fed tightening, offers better value, given the likely downward pressure on medium-term growth and inflation expectations that the Fed’s resolve implies.

The final mile is often the most difficult. While we hope that adage does not result in significant economic hardship in regard to the U.S. monetary policy, we also recognize that hope is not a strategy. Investors may need to prepare for a difficult final ascent.

Stephen Dover, CFA, is Franklin Templeton’s Chief Market Strategist and Head of the Franklin Templeton Investment Institute. Originally published in Stephen Dover’s LinkedIn Newsletter, Global Market Perspectives. Follow Stephen Dover on LinkedIn where he posts his thoughts and comments as well as his Global Market Perspectives newsletter.


1. Source: “Labor force and macroeconomic projections overview and highlights, 2022–32.” US Bureau of Labor Statistics. September 2023.

2. Source: Board of Governors of the Federal Reserve System. October 19, 2023.

3. Source: Fact Set, as of November 10, 2023. There is no assurance that any estimate, forecast or projection will be realized.


Content copyright © 2023 by Franklin Templeton. All rights reserved. Used with permission.

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