Fed wants to avoid ‘stop-and-go monetary policy,’ strategist explains

Putnam Investments Global Macro Strategist Jason Vaillancourt joins Yahoo Finance Live to discuss the Fed’s Christopher J. Waller’s warning on inflation and rate hike increases, consumer strength, the state of the labor market, and the outlook for the economy.

Video Transcript

- New commentary from Federal Reserve governor Christopher Waller reaffirming that the Fed expects to continue raising interest rates as they attempt to temper inflation. Our next guest knows they are still a ways away from declaring mission accomplished. For more, let's welcome in Jason Vaillancourt, who is the global macro strategist for Putnam Investments here.

Good to have you here with us this morning. First and foremost, when we think about the commentary that came forward from Waller over the weekend, he said that we should quit paying attention to the pace and start paying attention to where the endpoint is going to be. From your perspective, what does that endpoint look like?

JASON VAILLANCOURT: Yeah, I think that's right. I think-- and Powell tried to reinforce that in his press conference after their last meeting. You heard-- you talked to my colleague from Putnam, Jackie Cavanaugh, last week.

She talked about the terminal rate and the fact that the fed funds futures strip for 2023 is actually pricing in rate cuts near the middle part of next year, which seems incredibly aggressive and unrealistic. And so if you look at consensus forecasts for core PCE, they essentially for next year have them declining in a pretty much straight line from 5%, where they are now, down to about 2 and 1/2% by the end of next year in 2023. That also seems incredibly optimistic.

And so, look, the reality is the Fed doesn't really know where the neutral rate is. None of us know. It's unobservable.

But it's certainly higher than 4%, which is where Fed funds is now, and the Fed and Powell has talked about something closer to 5%. Waller's comments maybe indicated something between 5% and 5 and 1/2%, and that seems about right. And I agree that any kind of talk about a pivot is extremely premature, and we should be thinking more about the balance of risks.

And I think the balance of risks is for the Fed to maybe pause but then, if inflation isn't behaving as they expect, to maybe have to tighten Additionally in next year. And we don't really know. And obviously, I think the biggest question for markets is what happens if core inflation gets to something lower. We know inflation has very likely peaked, but what if inflation kind of gets down to 4% or 3% and then stays there? And I think that's the big question for the Fed is what do they do then if they can't declare mission accomplished on their 2% goal.

- What do you think they do?

JASON VAILLANCOURT: I think they're very likely to pause. They know-- Powell has said, obviously, that monetary policy works with long and variable lags. And so they maybe take a breath in the early part of next year and the first-- after the first third of the year and then see what happens.

But I think if we're at a point where inflation kind of flatlines something that's above-- at a level that's above 2%, above their goal, where they can't declare mission accomplished, it's very likely that they need to start additional rate hikes. We saw that obviously in the '70s and where they really want to avoid this stop and go policy. And I think if you look back at the papers that were presented at Jackson Hole, a lot of the research that they've done on the successes and failures of policy in the '70s, I think the idea is you want to avoid stop and go monetary policy. You want to be able to be consistent and stay on message, and I think that that's what they're trying to avoid through this cycle.

- Speaking of consistency, what does all this imply for stocks? I mean, you got Mike Wilson over at Morgan Stanley out today saying that we're going to go nowhere, that we're going to be at 3,900 at the end of next year for the S&P 500. What are you expecting?

JASON VAILLANCOURT: Yeah, Julie. I think that's-- obviously, Mike has been pretty spot on this year. I would agree. I mean, this does look a lot like previous bear market rallies that we've had in terms of size and scope and kind of risk on behavior. I had written in our capital markets outlook that I write for Putnam at the end of it, going into this quarter, that was very likely that we had one in this quarter, and that's kind of what we're getting.

Obviously, sentiment had gotten extremely depressed, and positioning had gotten extremely light. And so it seemed like we were pretty ripe for a rally. But I think, again, looking for markets to kind of grasp on to this kind of pivot I do think is premature.

And so I do think markets are going to struggle, right? As my Putnam colleague Jackie said last week, the consumer is still very strong. Consumer balance sheets are still very strong. The labor market is still really strong, and those are-- the irony is rallying equity market is actually easing financial conditions, and the Fed is trying to exactly do just the opposite.

And so I think our view, and if you look across most of our strategies, we're running with pretty low levels of risk. We're [INAUDIBLE] in our multi-asset portfolios underweight equity relative to their benchmarks and targets. And I think that's kind of likely to stick with that positioning, certainly probably through the first half of this year.

- You started to hit on some of my question there. What is the best kind of strategy for a portfolio with all of the different factors that are at play right now, and how much are you kind of-- how much are you shifting that strategy either day by day or willing to even kind of cut ties with certain portions of that strategy as things go on?

JASON VAILLANCOURT: Yeah, so we've been mostly underweight equities for the better part of this year. And I think that will likely to continue to be the case into the first part of 2023 as well. We've-- in our fixing of multi-sector portfolios, we've generally preferred to shy away from high risk corporate credit, so things like high yield, for example.

So most of those portfolios have kind of tended to shift up in quality and certainly from high yield to investment grade, even out of corporate credit into things like more structured credit-- high-quality, high-rated structured credit. And I think adding duration back, right? Obviously, we've had a pretty historic sell-off in interest rate risk.

You think about long treasuries this year. But we do think treasuries at nominal yields north of 4%, we've kind of had a little bit of a rally here in the last week or so. But I think adding duration to portfolios with 10 year yields at 4% or higher is the right thing to do as well.

I think the economy is likely to slow as we get into 2023. That's really the Fed's stated goal. And I think that that's going to provide a boost for duration for interest rate-sensitive parts of your portfolio that can help to offset some of the equity risks that you might have in your portfolio as well.

- Duly noted. Putnam Investments global macro strategist Jason Vailancourt. Good to see you. Talk to you soon.