The Fed Has to Keep Tightening Until Things

Get Worse
High inflation and an extremely tight labor market leave the Fed with
little choice but to tighten until the economy and markets weaken,
setting up as bad an environment for financial assets as we have seen.

SEPTEMBER 22, 2022

LARRY COFSKY
ALBERT CHEN

© 2022 Bridgewater Associates, LP

W
ednesday’s FOMC meeting—in which the Fed raised rates another
75bps, increased its forecast for peak interest rates to 4.6%, and
signaled that it would tighten as much as it takes to bring down
inflation—highlights that this cycle will be managed more aggressively than
what investors are used to because inflation is already at extreme levels. From
the mid-1980s until recently, the Fed tightened proactively and inflation
stayed relatively low and stable. This allowed the Fed the luxury of time,
so it could take a cautious approach to tightening and see how conditions
played out. With core inflation still north of 6%, unemployment at 3.7%, and
a record number of unfilled jobs, the Fed is now playing catch-up, and the
policy risk facing it is asymmetric—it needs to tighten a lot and can’t afford
to underdeliver or back down too early. This means that, at least in the near
term, the Fed is unlikely to welcome any easing of financial conditions, either
from lower interest rates or higher equity prices, that reduces downward
pressure on the real economy and prices. Chair Powell made it clear that the
Fed will not make the mistake of ending the tightening prematurely—and
acknowledged that this will not be a painless process.
While we think the tightening so far (and what the Fed is priced to deliver in the near future) is getting closer to
what it will take to slow the economy and rein in inflation, the thing we feel most confident about is this: today is
about as bad an environment for financial assets as we have seen. We don’t see stocks as pricing in the economic
pain that we and Chair Powell think it will take to bring inflation down. Until this happens or the economy slows
materially—which the Fed likely won’t be sure of for some time—we don’t see room for rates to fall.

USA Core CPI Inflation (6m, Ann) USA Labor Market Supply vs Demand
Start of Rate Hikes Unemployment Job Openings Est

7%
10%
With inflation too high and the 6% 9%
labor market too tight, the Fed
is chasing conditions 5% 8%
7%
4%
6%
3%
5%
2%
4%
1% 3%

0% 2%
1990 2000 2010 2020 1980 1990 2000 2010 2020

© 2022 Bridgewater Associates, LP 1

 USA 60/40 Portfolio Drawdown
USA 60/40 Portfolio Drawdown July FOMC Jackson Hole
0% 0%
-5% -3%
-10% -5%
-15% -8%
-20%
-10%
-25%
-13%
-30%
This year’s financial asset Markets didn’t take the Fed’s -15%
-35% fight against inflation seriously
sell-off is large versus those of
the last decade, but still small following the July FOMC -18%
-40%
when compared to other fights meeting, and the Fed pushed
with inflation -45% back at Jackson Hole -20%

1960 1980 2000 2020 Jul-21 Jan-22 Jul-22 Jan-23

60/40 = approximately 60% stocks, 40% bonds

There Is a Lot of Tightening Priced In and the Liquidity

Hole Is Getting Bigger, but the Fed Is Likely to Stay the
Course Until It Gets What It Wants
So far this year, the Fed has rapidly raised short rates from zero and transitioned aggressively from QE to
QT. This big swing in policy will eventually slow down the real economy via tightening financial conditions,
but with inflation so far away from target and with the lessons of the 1970s on the Fed’s mind, it will need
to see convincing evidence that it is nearing its goals before it turns toward easing. We think this will only
come via clear and repeated signs of relief on inflation or through a big sell-off in financial assets that would
unambiguously signal the kind of weakening in the real economy that will bring down inflation. Neither seems
forthcoming unless conditions, either real or financial, get worse.

Fed Funds Rate Fed QE (%GDP)

Fwd Pricing Fed Guidance
15%
8%

10%
6%

5%
4%

2% 0%

0% -5%
1990 2000 2010 2020 2010 2015 2020

© 2022 Bridgewater Associates, LP 2

Confidence That Imbalances in the Labor Market Are
Easing and Inflation Is Falling Enough Will Take Time
In previous research, we’ve written about how the labor market is still much too tight and inflationary
pressures much too broad for the Fed to pivot anytime soon. On Wednesday, Chair Powell reiterated that the
Fed will need to “achieve a period of growth below trend and also some softening of labor market conditions”
to get to its goals, and we think this “period” of weak growth could be longer and the “softening” more painful
than markets seem to. There is a material supply/demand imbalance in the labor market, which is driving wage
growth and putting inflationary pressures on the economy. These pressures can only be resolved by weaker
growth, but it’s impossible to say precisely how much worse growth needs to get. We think this uncertainty
will make the Fed reluctant to pivot until inflation is clearly falling, an outcome that will only become evident
with a lag.

USA Wage Growth and Services Inflation (6m, Ann)

Recessions Wage Growth Services Inflation
14%
Stubbornly high
wages anchored Historically, it’s 12%
inflation in the taken a recession
1970s to durably slow 10%
the pace of wage
growth 8%

6%

4%

2%

0%

-2%
1960 1970 1980 1990 2000 2010 2020

Atlanta Fed Wage Tracker (Y/Y) Atlanta Fed Wage Tracker: Job Switchers (Y/Y, 3mma)
Non-Smoothed Smoothed (3mma) Job Stayers Job Switchers
9% 9%
8% Historically large wage
premium for switching 8%
7% jobs suggests wage 7%
pressures remain strong
Sticky above 6% 6% 6%
5% 5%
4% 4%
3% 3%
2% 2%
1% 1%
0% 0%
1990 1995 2000 2005 2010 2015 2020 1990 1995 2000 2005 2010 2015 2020

© 2022 Bridgewater Associates, LP 3

Financial Markets Remain Too Optimistic About the
Growth Outlook—Which Is Not Helping the Fed
With conditions in the real economy unlikely to support a Fed pivot anytime soon, the only other shoe that
could drop would be a big tightening in financial conditions—one clearly large enough to trigger the Fed’s
desired growth slowdown. While markets, on Fed guidance, have priced in the Fed’s rate tightening ahead of
actual hikes, they have yet to price in any real growth slowdown and continue to see a pivot to persistently
tighter policy as unlikely. In other words, the change in rates has done most of the tightening so far, with no
help from changing expectations for growth.

USA Equities
Excess Returns (Indexed to EoY 2021)
Ex-Discount Rate Impact USA High-Yield CDX Spread

Rates are responsible 10% Spreads are biased

for most of the equity toward a continuation 1,750
sell-off this year 5% of easy policy
1,500
0%
1,250
-5%
1,000
-10%
750
-15%
500
-20%
250
-25%
Sep-21 Jan-22 May-22 Sep-22 2005 2010 2015 2020

And while the sell-off in equities, bonds, and spreads will eventually flow through to the real economy, with
conditions so far from target, we think the Fed will need to see more before it becomes convinced that financial
conditions have tightened enough to return inflation to 2%. This year’s sell-off in financial assets is large
relative to what markets have experienced over the past decade, but much larger ones have typically been
required to cause the Fed to pivot when inflation is this far above target.

© 2022 Bridgewater Associates, LP 4

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