Thursday, June 16, 2022
The Federal Reserve concluded its two day policy meeting yesterday and announced that it was raising its benchmark rate by 0.75% to a range of 1.5 – 1.75%, the first 0.75% move since November 1994. The possibility of a 0.75% hike seemed unlikely even a week ago, but an upside surprise in the latest reading of Consumer Price Index (CPI) index inflation, released on Friday, June 10, changed everything as short-term yields soared and market-implied rate hike expectations climbed higher.
“The Fed still has some leeway to remain credibly committed to bringing down inflation and they’re doing what they need to do,” said LPL Financial Asset Allocation Strategist Barry Gilbert. “But underneath the surface there’s not an easy fit between what they may have to do to bring down inflation and the soft landing they’re trying to achieve. The choices are going to get harder over the second half of the year.”
Here are four observations about yesterday’s rate hike:
- Raising rates helps control inflation by lowering demand, but as important it keeps expectations anchored. The Fed’s main fight right now is against long-term inflation expectations becoming unanchored, because once they are they are difficult to bring back down. As a result, the Fed needs to talk tough, it has been talking tough, and it’s been following it up with action. That’s part of why it thought the 0.75% hike was important. So far, it’s worked. Expectations have not yet become unanchored although there’s been some pressure.
- There is a point for rates where the economy breaks. The Fed is trying to slow growth so demand comes back down toward still constrained supply, but not actually push the economy into recession. We don’t know exactly where that breaking point is and the Fed isn’t necessarily going to get there. In the last cycle a policy rate of about 2.5% began to weigh on the economy, but there was also little inflationary pressure and the Fed was able to bring rates back down and maintain the expansion. The point that pushes the economy into a recession is higher. The median forecasted 2022 year-end rate of 3.4% in the new projections material may already be too much. There isn’t a bright line and the effects of monetary policy take time, but that breaking point is out there.
- With all the tough talk, the Fed isn’t yet facing the really tough decisions. The Fed’s median projected policy rate and projected economic growth rate seem inconsistent. The median forecast for 2022 growth is 1.7%. The average over the last expansion was about 2.3% each year. Those two numbers only sit together well if timing and circumstances are very friendly, which they rarely are. At some point in the second half of the year, the decisions are going to get much harder.
- If the fed funds rate is going to be lower than projected at the end of 2022, the Fed will need some help. Inflation has been the weak spot on the economy and has been stressed repeatedly. Supply chain disruptions. Excess stimulus due to a surprising robust recovery. A tight labor market with many older workers leaving the labor force. And then on top of everything else, high commodity prices due to the war and Ukraine. The easiest path to lifting some inflationary pressure would be supply chains materially improving, which they will eventually, and workforce growth. We do think it’s likely that some help is on the way. The question is whether it will come fast enough. We still tilt yes but uncertainty is rising.
Last Friday’s inflation report was a disappointment, and we believe the Fed’s response was appropriate and will contribute to a better inflation outlook over the medium run. At the same time, the odds of getting a soft landing are probably steadily moving closer to even. We do believe, however, that equity markets have already priced in even deeper skepticism about a soft landing. We have not yet seen the washed out sentiment typical of major market bottoms and we would not deny the added risk. But we think investors should be sticking to their plan and scouting out potential opportunities rather than heading for the exits.
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