Russia’s war in Ukraine and subsequent coordinated response from developed nations spearheaded by economic sanctions, perhaps most notably against Russian oil, adds to the specter of inflation and a decline in real wages. Inflation is large in scale (near 8 percent in the US), wide in scope (across goods and services in the consumer price index (CPI) basket, some of which have a lot of momentum), and shared by our trading partners globally (two-thirds of which have inflation above 5 percent). The public is worried about the pass-through of rising costs to prices and activity, probably more so than Federal Reserve officials.
The Fed has a difficult path to navigate; they must reduce financial accommodation or even exert outright restraint but not enough to trigger a recession. Despite the looming threat of stagflation, we do not believe the Fed will raise rates by 50 basis points at any subsequent meetings this year. They “feel the economy can handle tighter monetary policy.” Just as nature abhors a vacuum, Chair Jay Powell hates surprising markets. Our forecast is that Fed tightening as planned will let inflation run further above goal than they expect over the next two years.
In our view, a scenario where the Fed will adjust toward more aggressive future increases is less likely than the potential need to pause rate hikes. We maintain that the most likely scenario is a gradual march to a 1.75% fed funds rate by year-end. After two years of an effective fed funds rate of zero, we believe this hiking cycle should push money market fund yields to outperform bank deposit rates. Moreover, given the short duration of priced money market funds, we expect funds to capture the majority of the rate hike in relatively short order. We believe Dreyfus is well positioned against a backdrop of tightening policy.
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