The Federal Reserve Open Market Committee continued its aggressive tightening pace in the June meeting, by raising the key fed funds interest rate today by 0.75%—to a new range of 1.50-1.75%. This was the largest single meeting hike since 1994, and featured one dissenting vote (by a member favoring 0.50%). Why 0.75% and not 0.50%? It appeared the most recent consumer price index reading (still persisting around peak levels) and longer-term inflation expectations in the recent Univ. of Michigan consumer sentiment survey in recent days may have been catalysts for the stronger message and front-loading of hikes from later to earlier meetings.
The formal statement language noted that overall economic data has picked up since Q1, with a strong labor market, and elevated inflation. The committee noted that it is ‘highly attentive’ to inflation risks, highlighting this policy priority. In the accompanying data, their expectation of the fed funds rate for year-end 2022, 2023, and 2024 have risen to 3.4%, 3.8%, and 3.4% respectively.
At the end of last week, the CME fed funds futures market1 signaled overwhelming odds of a 0.50% move in rates, with only a slim chance of a 0.75% hike (as the Fed explicitly dismissed a 0.75% move only a month ago). That assumption changed early this week as a mysterious ‘whisper’ to some news organizations alluded to the strong possibility of a 0.75% hike. Despite happening during the Fed’s official quiet period of no public policy comments, this might have been considered forward guidance, albeit through an informal channel. Financial markets reacted swiftly to the downside on Monday, with U.S. stocks officially falling into a -20% bear market after teetering on the brink for over a month, but calmed in recent days as the new information was absorbed.
In looking at the futures market for year-end 2022, the highest probabilities for the fed funds rate have moved up to a range of 3.50-4.00%, well above the long-term ‘neutral’ rate estimated by the Fed (still around 2.5%). But, interestingly, the furthest-out available estimates, June and July 2023, see the highest probability at a similar 3.75-4.25%. This appears to be the market’s current estimate of the terminal rate. These longer-dated contracts have jumped by over a half-percent over the last few weeks with continued high inflation readings.
Based on comments from FOMC members in their normal rounds of speeches, there seemed to be a general view that they’d like to be close to their estimated neutral rate by around year-end. That could be out of date, since year-end could see rates beyond this. While the long-term neutral rate level hasn’t changed, the timeline for fighting inflation has sped up. The classic view is that under periods of higher-than-desired inflation, monetary policy requires tightening the short-term rate above the neutral rate, applying enough contrary slowing pressure to bring price levels back down to target. Fast hikes do add water to the inflation fire, and a more proactive/less reactionary policy has been demanded by quite a few economists and politicians. However, it also raises the risk of a policy error compared to a more conservative hiking policy, say with 0.25% or 0.50% moves, as rate changes operate with a lag in the economy.
Quantitative tightening is the other issue at hand. During the pandemic, the size of the Federal Reserve balance sheet doubled from its prior peak to $9 tril., with extensive buying of treasury and mortgage-backed debt. This has started to be unwound, in small steps, as money from maturing securities owned essentially won’t be reinvested, subject to monthly ‘caps’. These caps allow unwinding to be better managed, as well as send clear communication to the bond market about how much is being unwound, and avoiding surprises that could exacerbate interest rate volatility. Based on current expectations, over $2 tril. will come off the balance by the end of 2024. This is progress, but no doubt the overall balance sheet size will remain larger than normal for several more years.
The Fed’s evaluation metrics remain mixed, in terms of high inflation being offset by strong labor markets, and decent, but decelerating, economic growth fundamentals. The Fed’s Summary of Economic Projections (SEP) reflected the updated assumptions, and are noted under each respective category below.
Economy: Economic growth projections for Q1 and 2022 as a whole have fallen in recent weeks, on top of the first quarter’s final -1.5% result. The Atlanta Fed’s GDPNow estimate, based on real-time data, has fallen in the past week from 0.9% to 0.0%—not much room for error. The Fed SEP for June showed an expected decline in GDP growth from 2.8% to 1.7% for this year, with similar results for 2023 and 2024, more in line with long-term trend. Similar reduced growth expectations by the World Bank and private economists have raised concerns about recession within the global economy. U.S. growth has been running at a stronger rate than in Europe or Asia, where China has pulled down growth numbers due to the just ended but fragile Shanghai lockdown. But the U.S. growth rate remains weaker than hoped at this point, as reopenings from the pandemic continue toward a more ‘normal’ level of functioning. The good news is that although recession risk has re-elevated, other late cycle tendencies, such as elevated corporate borrowing and low interest coverage ratios, don’t appear to be at troublesome levels. This reduces the risk of a deeper downturn fueled by default activity.
Inflation: The May headline CPI release showed trailing 12-month gains of 8.6% and 6.0% for headline and core, respectively2. Core CPI is now running below the March year-over-year peak (although not by much), with eager anticipation toward when prices start to turn the corner downward. The SEP showed inflation expectations (PCE rather than CPI) for full-year 2022 at 5.2%, followed by more tempered results of 2.6% and 2.2% in 2023 and 2024.
Inflation has been running at year-over-year rates not seen in 40 years, with an entire generation of Americans unfamiliar with this new environment. Inflation is obvious in daily consumption items like food and gasoline, which affect low income earners more severely. It can also spin into a ‘wage-price spiral’, if sustained long enough for workers to demand higher pay in order to keep up. Such a scenario has been one of the biggest concerns of economists, as a spiral can be difficult to undo once begun. As it stands today, the key question remains—how long will elevated inflation last? Some of that is answerable: as supplies for items like computer chips and cars normalize, year-over-year rates of increase from base levels drop, slowing the inflation cycle. This puts out the fire, so to speak. The second part is unanswerable, dependent on several fluid factors such as the Chinese Covid response (improving for now), and the Ukraine/Russia conflict (with no signs of abatement, and fears of a plodding multi-year fight).
There is an important secular inflation component, which is slowly being acknowledged by the broader economic community and some politicians. This puzzle piece is the large fiscal stimulus injected by the U.S. and other world governments in response to the pandemic. While M2 balances (a common measure of broader money supply) have stopped rising at exponential rates, excess cash in the system remains high. This can either be hoarded as reserves/savings or spent. If spent, the buying demand pressure already seen in physical goods can be shifted into spending on services, which has started to happen.
Employment: Labor markets remain stable, which in this case is a positive, as the data remains quite good. In fact, a variety of measures remain as strong as they’ve been in decades, from job openings, payrolls, low jobless claims, as well as nuanced measures like quit rates. The SEP unemployment rate estimate ticked up 0.2% from March to 3.7%, with 3.9% and 4.1% remaining the base-case for 2023-24. This is fairly close to what’s considered ‘full employment’, as much as that can be estimated. The durability of these data points for so long reflects the fact that they can’t really improve much further from here, and more than a million potential workers remain on the sidelines for reasons still being debated. Early retirements have accounted for some of the gap, as have dependent care concerns, long Covid, and lower immigration activity.
Financial markets appear to be looking for more certainty about the Fed’s path. Unfortunately, that path is fluid, as inflation has been far more sticky than many (and the Fed) have hoped. For central banks, it’s about taking control of the narrative, which continues to be a challenge. Recent volatility reflects that uncertainty about all the inputs discussed above, especially inflation and the interest rate path designed to get it controlled. Although it ‘feels’ like returns have been far worse than they are, the S&P 500 has bounced around the -15% correction to -20% bear market area for over a month, after initial volatility in Feb. and Mar., with breaks of recovery in between. The sell-off has not spiraled radically downward into deep crisis, like we saw briefly during the early pandemic’s -34% drop. For perspective’s sake, the median pre-recession bear market since WWII has troughed at just above -25%, which isn’t far from today’s level.
While a recession usually isn’t something wished for, it can be occasionally useful, as one of the better methods of generating demand destruction—an effective method for stopping inflation and cooling overheated parts of an economy, such as overly tight labor markets and high commodity prices. This can set up a ‘reset’ toward more normal levels when the new cycle begins. But, again, this could jumping the gun, and such a scenario could still be a ways out. Then again, weaker data more recently may prove that we’re in recession now, making the equity market correct more quickly than usual.
As issues resolve, or even improve, volatility has tended to historically lessen. However, volatility may not be over as financial markets grapple with how to digest higher interest rates across the board and an end to ‘easy’ monetary policy for this cycle. The inflation story is already well-trodden, but the timeline and path of Fed policy is the open-ended question. Hopes remain for a ‘soft landing’, which is defined as a tightening of financial conditions that doesn’t result in a recession. This has been accomplished several times (notably in 1984 and 1994), but is not assumed to be the norm, and the poor market sentiment reflects that lower probability of success. Financial markets are well aware of the mixed to poor historical track record of the Fed’s ability to ‘tame’ inflation without causing a recession first. Thus, the investor risk-taking mood is extremely negative, which makes for dour news headlines, but does tend to be a good contrarian bullish sign for taking risk looking forward.