Breadth Thrusts & Bread Crusts - Catching Up With The Fed

JC Parets
March 17, 2022

From the desk of Willie Delwiche.

To the surprise of no one, the Federal Reserve voted to raise its target fed funds rate at yesterday’s FOMC meeting. The 25 basis-point rate hike was fully priced into the futures market. There was only one dissenting vote – St. Louis Fed President Jim Bullard expressed a preference for a 50 basis point hike at this meeting. 

I’ll admit I was surprised that neither Esther George (from the Kansas City Fed) or Loretta Mester (from the Cleveland Fed) joined Bullard in his dissent. At the end of the day, the Fed is now in tightening mode, and the pace of tightening is likely to pick up over the course of the year between the combined effects of interest rate hikes and balance sheet drawdowns.

I’m not going to parse the FOMC statement, dissect the dot plot, or break down the summary economic projections. Much of what needs to be said (and a lot of what didn’t need to be said) about the Fed’s decision has been offered in print, over the airwaves, and in our virtual communities.

The received wisdom is that initial rate hikes tend to be benign and that equities actually rally in the wake of rate hikes. One can certainly assemble the data in a way that fits that conclusion. I would offer a couple of caveats that suggest this tightening cycle may have dissimilar effects to those of the recent past. 

First, the Fed is behind the curve with respect to other central banks. In the recent past, the Fed has led the way when it comes to tightening cycles. In the current case, a majority of global central banks had already begun to raise rates by the time the Fed reached its decision to do so. The equity market implications are not positive. All of the net gains in equities over the past 30 years have come when a majority of central banks have been lowering rates, not raising them. 

Second, the Fed is behind the curve with respect to bonds and inflation. Surging inflation over the past year caught the Fed flat-footed and it now needs to play catch up. The real fed funds rate (fed funds rate less CPI inflation) has never been more negative than it is now. This puts a more aggressive tightening path on the table. Fed fund futures currently see a 50% chance that either the May or June FOMC meetings will bring a 50 basis point rate hike, and another 25% chance that both of them will. The market in the past has done a good job of absorbing a slow and steady pace of tightening, but has struggled in periods when the Fed has had to raise rates quickly. The latter case seems to be in store in 2022. 

Through a skillful combination of steering and braking, it’s possible the Fed will complete this turn without scraping the wall. But by being late with its initial adjustments, the need for aggressive action has increased. So too have the risks of an accident. 

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