The challenges of the Fed’s triple mandate

While the Fed’s mandate is commonly viewed as a dual mandate – that of price stability and maximum employment – in reality, the Fed has a triple mandate. Since 1977 it has been mandated by Congress to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates“.

Then why do experts and market participants refer to it as a dual mandate? Mainly because it is often thought that a sound and effective monetary policy, which ensures maximum employment and stable prices, would naturally and automatically result in moderate long-term rates.

In today’s high inflation setting, central banks have been late at raising rates after nearly a decade and a half of easy monetary policy, thus resorting to aggressive hikes which have raised the expectation of economic slowdown and/or recession. This unusual set-up, in our view, makes all three vectors of its triple mandate even more relevant, as the significance of long-term rates becomes as relevant as price stability and employment.

The economic picture in the US is particularly interesting and complex. The US is in technical recession, while inflation has exceeded 9% and very strong unemployment numbers surprised the market on August 5th by bringing the unemployment rate to pre-pandemic lows of 3.5%. So, what scenarios is the economy likely to face?

1. Market prices (i.e. a potential slowdown in early 2023) driving the Fed to cut rates (after raising them to over 3.5% by end of 2022).
2. Continued/sustained inflation – potentially via rising wages given the potential for a buoyant and tight job market if unemployment numbers continue to surprise. This will likely force the Fed to be ever more aggressive in raising rates.
3. Incoming data in the next few months indicating that inflation appears to have peaked, yet unemployment drops continues at a healthy pace.
4. Alternative paths such as one where unemployment data normalizes while inflation subsides. This would be a path that the Fed would particularly welcome.

The important question for investors is how to gauge expectations of what might happen to long-term rates under each of these scenarios. In the case of an economic slowdown/recession one would expect long-term rates to be contained or to drop. However, a tight labor market combined with inflationary pressures due to wage increases and continued Quantitative Tightening does present a reasonable risk for long-term interest rates to awaken and resume their march higher.

After a spectacular rise in the first half of 2022, peaking at 3.5% in June, 10-year US rates have been generally range bound and well behaved. But it is important not to get too comfortable following this relative calm.