The Fed’s Search for Balance

William Sterling, Ph.D.

Last month, the Federal Reserve raised its benchmark federal funds rate for the first time since 2018. The highly anticipated move is now driving a wider conversation on how high interest rates can go from here, and by extension, is the US economy inching closer to a recessionary period.

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As the Fed “hits the brakes” on loose monetary policy, leading indicators point to a 3% rate peak in December 2024, followed by an easing in 2025. Presumably, this outcome will be due to an economic slowdown and easing inflationary pressures by then. As of early April, Fed funds futures now price in a 79% chance of a 50 bps rate hike on May 4 and a 100% chance of a 50 bps hike at two out of three FOMC meetings by July.

Yet reliance on this metric can be tricky at best. This “hairy caterpillar” chart below shows how wrong federal funds futures have been in the past. The most poignant example is the 2020 prediction of a funds rate at zero through 2024.

Federal Funds Rate Actuals vs. Market Expectations as of Mid-March Each Year

Note: Shaded areas denote NBER recession periods.

Source: GW&K Investment Management, NBER and Macrobond

Given Powell’s framing of the Russia shock and his intention to get inflation “back under control,” it is worth looking at the history of Fed rate-hiking cycles to get a sense of how financial markets have historically responded. Looking back at periods when geopolitical uncertainty intersected with high inflation and Fed tightening can give us clues on what to expect in the current environment. 

While the futures guessing game continues, the Fed is hardly in uncharted territory. In fact, as shown in the table below, the current tightening cycle has more in common with four separate cycles occurring in 1947, 1974 and 1980.

Fed Tightening Cycles Since World War II Have Averaged About Two Years and Resulted in an Average Hike in the Fed Funds Rate of 4%

Note: Four highest inflation periods shaded in red: 1947, 1974, 1977, 1980; Four lowest inflation periods shaded in blue: 1954, 1961, 1999, 2015 *Treasury bill discount rate used before 1954.

Source: GW&K Investment Management, Federal Reserve and Macrobond

It’s also worth noting that Fed tightening cycles have had very different initial conditions with respect to both inflation and unemployment. Yet, despite the recent increase in the federal funds rate inflation remains—in the view of the Fed—unacceptably high. Inflation above 7% has clearly caused the Fed to pivot toward monetary tightening, and “transitory” has been retired from the lexicon.  Further, the Fed’s decisively hawkish pivot has flattened and partially inverted yield curves, suggesting rising recession risks. 

Timing recessions—or timing the market for fear of recessions—can be a complicated business. What we do know is that in general, Fed rate hiking cycles have often been followed by recessions, but the timing has varied widely: from 11 months after the first hike to as long as 86 months! That is an average time of 37 months or the equivalent of more than 3 years!  

Timing recessions—or timing the market for fear of recessions—can be a complicated business. What we do know is that in general, Fed rate hiking cycles have often been followed by recessions, but the timing has varied widely: from 11 months after the first hike to as long as 86 months! That is an average time of 37 months or the equivalent of more than 3 years!  

As the Fed continues to hold fast to pursuing its dual mandate, economists now expect inflation to head back to the mid-to-low 2% range over the next year caused by easing supply chain pressures, a recovery in labor supply, and a rotation in consumer spending away from overheated goods markets back toward services. Despite current economic conditions, the Fed is also projecting a soft landing for the economy, with inflation returning close to the 2% target, and labor market tightness continuing with a 3.5% unemployment rate in the longer run.

Chairman Powell has indicated a willingness to be ready to respond to economic changes as needed. Will his search for balance calm inflation? The verdict remains to be seen. However, all signs point to continuous rate hikes over the next few quarters.

This represents the views and opinions of GW&K Investment Management.  It does not constitute investment advice or an offer or solicitation to purchase or sell any security and is subject to change at any time due to changes in market or economic conditions. The comments should not be construed as a recommendation of individual holdings or market sectors, but as an illustration of broader themes.

 

Past performance is not a guarantee of future results. Investing involves risk including possible loss of principal.

 

This does not constitute investment advice or an investment recommendation.

 

Any securities discussed herein do not represent the entire portfolio and in aggregate may represent only a small percentage of a portfolio’s holdings, or, may not be held in an account’s portfolio at all. It should not be assumed that any of the securities transactions discussed were or will prove to be profitable, or that the investment recommendations we make in the future will be profitable or will equal the investment performance of any security discussed herein.

WRITTEN BY

amg-funds-image-william-sterling

William Sterling, Ph.D.

PUBLISHED: April 28th, 2022
3 Min Read

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