Fed Makes Unusually Large Rate Hike, Expects Rates Over 3% By Year End
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The Fed today emphasized that it is “strongly committed” to bringing down inflation. To that end interest rates were raised by 0.75%, the Fed hasn’t made a move that large in over 20 years, but then inflation is running at levels not seen in around 40 years. The most recent CPI report did not provide much comfort that U.S. inflation is under control prompting the Fed to make a large move in rates.

Fed policy makers now believe that interest rates will end 2022 at around 3.5% and perhaps exceed 4% in 2023, compared to 1.25%-1.5% after today’s meeting. So if that prediction holds, then rates still have further to increase over the coming months. Markets broadly agree with that assessment.

Recession Risk

However, there are several uncertainties in terms of how monetary policy may play out from here, given that the Fed takes a data dependent view when setting policy.

The first issue that the S&P 500 is now in bear market territory. That typically means a recession is coming. The U.S. Treasury yield curve is also partially inverted, which can be another recession predictor. Finally, the first quarter saw negative economic growth, though that may have been due to unusual swings in foreign trade.

As much as the Fed wants inflation lower, the other primary part of their mandate is to maintain robust employment. A recession, if it comes, wouldn’t help with that. The U.S. employment situation is strong for now, but if that falters then the Fed will have a more difficult trade-off between inflation and jobs. However, some believe it may take a recession to tame inflation, which is running at 8.6% on most recent CPI data, well above the Fed’s 2% target.

Market Implications

Markets have already pricing in rising rates and potential risks to growth, so today’s news is no big surprise as markets adjusted to the chance of a 0.75% move in recent days. The bond market broadly expects further rate hikes from here. Further meetings are expected to see big moves up in rates, larger than the usual 25bps increments the Fed commonly moves in.

The stock market too has sold off over recent months. Some of that was perhaps due to valuations being relatively elevated, but it is, in part, a reflection of expectations of slower growth going forward and the risk that the Fed’s actions in attempting to bring down inflation may slow economic growth.

It was notable that today’s Fed move didn’t have complete consensus. Policy maker Esther George would have liked to move up rates by 0.5% rather than 0.75%. If inflation does start to come down and recessionary risks increase, then the Fed will have a delicate balancing act on its hands. For now, their goal is clearly to tame inflation.

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