Over recent months, FOMC communications have increasingly reflected support for an overshoot of the two percent inflation objective. This dovish policy stance is part of a new strategy that will be formalized around the middle of next year. Most importantly, the Committee’s inflation pivot suggests that rate hikes remain very far off. By supporting financial conditions and potentially lengthening the expansion, the inflation pivot has provided an opportunity to selectively take risk in multi-sector portfolios. Still, with the economy exhibiting some late-cycle dynamics, we have looked to do so in a prudent manner, focusing on further diversifying alpha sources.

Since the October FOMC meeting, Federal Reserve policymakers have signaled that their three rate cuts this year should suffice to stabilize growth around trend and extend the economic expansion. Only a material downshift in economic data would lead to further policy easing. We believe, however, that focusing on the end of insurance rate cuts obscures a much more important shift in the policy outlook, one with repercussions that could extend far beyond next year. Namely, in his post-meeting press briefings in October and December, Chairman Powell noted that any increases in the policy rate should only follow a persistent and significant pickup in inflation. If supported by the Committee – and we believe it will be - this approach would represent a significant shift in how the FOMC has reacted to inflation developments in recent years, when they implicitly treated their two percent objective as a ceiling. Most importantly, the new approach suggests that even if trade policy risks fade and growth remains around its long-run potential next year, the FOMC will not take back this year’s insurance cuts any time soon. In fact, given limited inflation pressures, we believe rate increases are off the table for at least the next two years.

Powell’s shift in thinking on inflation can best be understood in the context of the Committee’s review of its monetary policy strategy. Since early this year, the Committee has been reassessing its approach to monetary policy given a very low neutral interest rate1, and against a backdrop of weak inflation outcomes and risks that inflation expectations have already slipped below the Committee’s two percent objective. If the neutral rate is indeed low by historical standards, then there is less policy space to cut rates into stimulative territory in future recessions. This in turn implies a greater frequency and longer duration of episodes where the economy is operating below its potential, with elevated unemployment and weak inflation, and with the policy rate stuck at its effective lower bound.2

One emerging conclusion from the Committee’s framework review is that the frequency and length of stays at the lower bound can be reduced by targeting higher inflation outcomes during economic expansions. The exact form this strategy will take is still under discussion, but Fed communications suggest growing support for an approach that seeks an average level of inflation between 2 and 2.5 percent over the remainder of this expansion. This would represent a meaningful and dovish shift in the Committee’s policy reaction function.

An emerging preference for higher inflation during expansions likely motivated Powell’s recent comments arguing against rate increases until there is a persistent and significant pickup in inflation. While he has not specifically defined the inflation outcomes he seeks, when asked at the December press briefing about changes to the inflation objective Powell stated his preference that the strategy review result in “meaningful improvements.” He also noted a number of Committee participants are now including inflation overshoots in their projections for appropriate policy.


Powell’s comments and the Committee’s strategy review suggest greatly diminished odds of rate increases over at least the next two years. This outlook is increasingly being reflected in Committee projections for the policy rate in the years ahead (Figure 1). Ongoing Committee deliberations will continue to influence these projections. The March and June projection rounds will likely reflect further policy accommodation, with a flatter rate path supporting higher inflation outcomes.3

The current policy outlook represents a notable difference from the prior two episodes where the Committee cut rates to extend expansions, in 1995-96 and again in 1998. In both those instances, the Committee resumed policy tightening once it was confident that its actions would extend the expansion. With the Committee now signaling comfort with inflation eventually persisting above two percent, we believe any resumption of policy tightening remains far off. As such, investors are unlikely to price in rate increases for the foreseeable future. In contrast, in 1995-96 and 1998, investors began to price in higher policy rates within several months of the final rate cut (Figure 2).


Multi-Sector Portfolio Implications

The recalibration of the FOMC’s policy strategy, has for several months, informed positioning in MacKay Shields’ multi-sector portfolios. Notwithstanding that a more dovish policy supports higher valuations and total return. We remain cognizant that the economy is exhibiting some late-cycle dynamics. Accordingly, our credit exposure in multi-sector portfolios continues to be conservative. Within credit we remain focused on shorter duration opportunities within BBB and BB rated credit (where permitted). Additionally, we prefer financials, telecommunications and select consumer companies while remaining underweight energy and CCC rated credits. Investment grade exposure continues to be higher than average across the cycle with high yield being in the low end of our strategic range. While we continue to execute our late-cycle strategy we have looked for opportunities to prudently enhance total return in portfolios. Given our focus on diversifying sources of alpha we have emphasized the following strategies:


1The neutral rate is the level of the policy rate that would keep the economy at full employment and inflation at the central bank’s objective over time.

2 As the Committee has signaled little appetite for negative interest rates in a recession, the effective lower bound for the fed funds rates is essentially zero.

3FOMC participants release economic projections, including projections for the policy rate, once each quarter.

4 Implementation of these strategies is subject to permissibility in portfolio guidelines.

Definitions

FOMC: Federal Open Market Committee, United States Federal Reserve

Committee: Federal Open Market Committee, United States Federal Reserve