The Federal Reserve Open Market Committee raised the key fed funds interest rate today by 0.25%, to a new range of 0.25-0.50%. This first hike in four years was as expected, with the Fed communicating their intention and amount fairly directly in recent weeks. However, at least until the Russian invasion of Ukraine, there was debate about whether the hike could be as high as 0.50%. In fact, there was one dissent in the committee decision, by Fed St. Louis President Bullard, who preferred the 0.50% hike.
The formal statement language noted that economic conditions continue strengthen, led by job gains. However, inflation was acknowledged as remaining elevated, but to ‘supply and demand imbalances.’ The Russian invasion of Ukraine was mentioned, with future impacts remaining uncertain, but are likely to push inflation upward, and weigh on economic growth downward.
The ‘dot plot’ implies up to six hikes for 2022, to just under 2.0% by year-end, and several more in 2023, to a rate of 2.8%. Member projections for inflation are up from last December, while economic growth projections have fallen (the latter from 4.0% to 2.8% for 2022, and back to a normalish 2.0-2.2% for subsequent years. When reviewing the fast-changing fed funds target rate probability markets1, just prior to the meeting, the largest current prediction fell at about 2.00% by December, and 2.50% by June 2023, so not far from Fed projections. Notably 2.50% is the long-term Fed neutral rate target, which implies the Fed feels it may need to reach further above that neutral rate to control inflation. The Fed has also promised to reduce the balance sheet sharply, perhaps starting as soon as May and into the summer, which has the impact of making policy more restrictive (albeit more untested than interest rates). These numbers are obviously estimates, and subject to change, but offer some insight into behind-the-scenes thinking relative to the last meeting in December.
The Fed’s evaluation metrics are increasingly mixed (and more fluid than usual):
Economy: Economic growth projections for Q1 and 2022 as a whole have fallen, although more so in Europe than in the U.S. Strong growth in 2021 came as economic reopenings from Covid accelerated, albeit in fits and starts. This year’s growth was already expected to decelerate sharply—it has just done so faster than expected. The Atlanta GDPNow measure is predicting a rate of 1.2% for Q1, while the range of Blue Chip economist estimates now falls between just under 1% and 3%. No doubt the wide range reflects the uncertainty of the current environment, with the Ukraine situation and high commodity prices now controlling factors.
Inflation: The most recent February CPI release noted 7.9% and 6.4% for trailing 12-month headline and core, respectively2. This is the fastest pace in 40 years, since the early 1980’s high inflation era brought down by Fed Chair Volcker. Debate has continued about whether this inflation challenge is transitory (still hinged on supply/logistics issues related to Covid) or based on expansive monetary and fiscal policies. But, no doubt the more recent secondary surge is tied to commodity prices. In particular, along with wages, fuel prices are a strong and visible input to near-term consumer sentiment—which tends to turn negative when per gallon prices spike, as this represents a higher percentage of lower-income budgets (and angers voters). Globally, continued high prices can weigh on spending in other sectors and represent one of the primary economic growth risks. Jerome Powell, and the Fed generally, have been criticized a bit for underestimating the rise in inflation. In their defense, economists and policymakers have generally been in agreement of their real-time assessments of the situation and risks; it’s just that conditions continue to evolve and have done so rapidly in recent weeks.
Employment: On the positive side, labor markets have continued to improve by nearly every official measure, in jobless claims, job openings, nonfarm payrolls, and the unemployment rate. Importantly, data points such as the quit rate, remain at high levels, showing that workers have ample choice for employment, and employers are scrambling to find qualified workers. This part of the economy appears to be firing on all cylinders.
How times have changed. This meeting was the ‘big one’, in terms of it being the well-awaited liftoff for interest rate hikes. The Fed finds itself between a rock and a hard place, with seemingly no ideal path. Inflation (from multiple factors) and stronger labor markets point to a pressing need to raise interest rates from near-zero emergency conditions. However, the impact of the war in Ukraine and sanctions that have pushed oil and other commodities higher this year have also tightened financial conditions on their own—doing some of the Fed’s job for it.
Prior to the war in Ukraine, economic growth was beginning to already decelerate from last year’s super-charged levels. Now, global growth is under greater threat from higher commodity prices, including crude oil and natural gas, but also metals and grains, which raises food prices (another sensitive area for global consumers). Although the U.S. is less directly sensitive than is Europe, spending could be pulled down globally. A key constant over the past few decades has been the negative influence of higher energy prices on economic activity. This is true even though consumers are less directly reliant on petroleum than decades ago, although current military activity is still being compared to the Yom Kippur war of 1973 and subsequent oil embargo. While not all recessions have been tied to oil price spikes, such spikes have tended to raise the risk of recessions. Today’s weak point is that nearly half of Europe’s natural gas used originates in Russia, which has kept that channel free of sanctions for the time being.
This situation remains extremely fluid, but from a monetary policy standpoint, it remains unclear whether this could lead to potentially fewer and a slower pace of rate hikes than what might have been estimated just a few months ago, or a faster pace to contain inflation. This process will have to be managed carefully to avoid a policy mistake. On the positive side, should progress be made in stopping the Ukraine conflict, commodity price pressures could also ease quickly, which should provide a clearer path to normalizing policy without growth hurdles getting in the way.
Accordingly, worries about ‘stagflation’ have again flared up, although the diagnosis may be premature. In the 1970’s, this referred to problematic inflation caused by high commodity prices, coupled with tempered GDP growth. (It’s important to note that U.S. growth still averaged over 3% for that full decade, a rate we’d be happy with today, since 2010-2019 growth was sub-2%.) Stagflation is a condition most central bankers seek to avoid, as both inputs are negative, while potential solutions are contradictory—inflation points to contractionary policy/higher rates, while slow economic growth warrants easing/lower rates. The Fed seems more focused on moving to combat the most destructive and potentially persistent force, in which inflation wins today. This gets back to questions about the source and persistence of underlying inflation—whether it be caused by supply shock (goods-based, transitory) or demand-stock (fueled by fiscal stimulus spending, persistent)—which looks to be a key question for 2022. Inflation is also politically problematic, so in a mid-term election year, expect much more chatter there as well. Most importantly, the Fed may feel the need to enhance its inflation-righting credibility, which has come under some scrutiny as of late.
How does this changing Fed regime affect fixed income markets? The short-end of the yield curve moves along with fed funds rates and near-term rate expectations. The longer-end is more difficult to predict, as rates are driven to a greater degree by economic growth and long-term inflation expectations (which remains surprisingly anchored in the 2-3% range, as noted by implied inflation breakevens and consumer sentiment3). On the plus side for bond investors, higher rates eventually raise expected returns, which more conservative investors have been waiting for. Adding to the Fed’s concerns is further flattening of the yield curve, which would occur more dramatically if the fed funds continues to rise and long rates move by a lesser amount, or fall. (The spread between the 10-year Treasury and 2-year Treasury has declined from 1.3% last fall to 0.3% today. Then again, the 10-year itself has fluctuated between 0.5% to over 3.0% over the past few years. These are not perfect measures and adjust quickly in real time.) The signal is that flatter curves correspond to lukewarm future market expectations. A sharp economic deterioration doesn’t appear to be the base case, but the risks have risen from a few months ago as this economic cycle seems to be moving more quickly than the last one.
2U.S. Bureau of Labor Statistics
3Federal Reserve Bank of St. Louis, Trading Economics