It's All About Inflation

July 28, 2022

City people walking in a futuristic tunnel

Jim Palmer, CFA, Chief Investment Officer

Wednesday’s strong equity market rally would disagree, but if you’re looking for a Federal Reserve (Fed) put on your market positions, you’ve come to the wrong place. The same goes for those unprepared for a recession. The Fed has made it clear inflation is public enemy #1 and if markets falter and unemployment rates rise, so be it. 

Of course, slowing the economy is the whole point.

Chairman Powell explicitly said as much during his post-meeting press conference. But in some ways, the Fed has relatively benign circumstances to front-load rate hikes. The U3 unemployment rate is at 3.6% and there are still more than five million open jobs above the current total unemployed workers in the labor force. Labor markets may moderate in the coming months, but are starting from a position of considerable strength. Let the politicians argue whether the economy is in recession or not, it doesn’t matter to the Fed at this point.

The Federal Reserve Open Market Committee (FOMC) kept applying the brakes and lifted rates another 75 basis points (bps), the third jumbo-sized rate hike in a row. This time, the debate was between a 75 or 100 bps rate hike. The hotter-than-expected June Consumer Price Index released on July 13 pushed the probability of 100 bps at the July 27 meeting to well over 50%. Several Fed officials pushed back, publicly leaning toward 75 bps just before the Fed’s public comment blackout period began. Given the FOMC vote was 12-0, there was little disagreement on the decision among policymakers. 

In the grand scheme of things, does it really matter whether the Fed raised rates 75 instead of 100 bps? Probably not. But at one point, Powell suggested policy rates were at neutral, which seems like an unforced error. Using even a generous long-term view, real policy rates — measured by the high end of the Fed’s target range (2.50%) minus the five-year Treasury Inflation-Protected Securities break even rate (~2.60%) — are still negative. Implying monetary policy remains stimulative. If the Fed is serious about getting inflation moving in the right direction, policymakers must keep tightening until real rates become restrictive. The Fed is on the right path by front loading rate hikes, especially given our sense the markets are biased to push back against at every opportunity. The Fed is close, but still has work to do. Better to act while the window is open. 

In short, the sooner you get to your destination the sooner you can stop. 

A few key points from Wednesday’s Fed meeting and Chairman Powell’s press conference:

  • The fed funds target range was raised 75 bps to 2.25% to 2.50%. 
  • The overnight reverse repo rate was raised to 2.30%
  • There were no changes to the anticipated monthly pace of balance sheet reduction ($47.5 billion cap for June through August and $95 billion cap starting in September). 
  • Chairman Powell said future rate decisions are data-driven and no decision has been made “at all” for the September 21 meeting (we think 1. inflation data trumps growth data, 2. data dependency invites greater yield curve volatility, and 3. less forward guidance improves Fed credibility by avoiding policy reversals). 
  • Post-meeting Fed funds futures are leaning toward a 50 bps (70% probability) vs. 75 bps (30%). (Given the amount of data set to be released in the unusually long eight-week span between Fed meetings, Fed rate forecasts are pretty much pure speculation. Which we are hardly above doing. We lean toward 50 bps on our expectations growth will be slower and inflation, while still too high, will be at least trending in the right direction.) 
  • Futures are pricing in a 3.25% to 3.50% terminal federal funds range by the end of 2022, with rate cuts beginning in the second half of 2023 (which seems aggressively early to us).

Bloomberg, FOMC Dot Plot and World Interest Rate Probability

FOMC Press Release, July 27, 2022