Fed stands firm on rate increases

Federal Reserve Chairman Jerome Powell used last Friday’s speech at the annual Economic Policy Symposium in Jackson Hole, Wyoming, to deliver his most hawkish message to date on the US central bank’s determination to tame surging inflation by raising rates. Wall Street reacted negatively to Powell’s highly expected address, with the S&P 500 and Nasdaq Composite both registering their biggest one-day decline since mid-June, amid renewed concerns that the Fed’s policies would lead to weaker economic growth, rising unemployment, and lower corporate profits.

Financial markets had rallied in recent weeks amid expectations the Fed might ease up its efforts to curb demand as economic data deteriorated further and concerns grew over the risks of being too heavy-handed. However, Powell’s latest speech strongly indicated that the central bank was focused squarely on bringing inflation down, even at a cost to economic growth and unemployment. He even mentioned that there may be “some pain” to households and businesses and a weaker jobs market.

Although Powell’s message does not represent a change in the Fed’s policy stance, it was the clearest expression of the Fed’s intentions from the chairman on the need to keep tightening monetary policy “until the job is done”. Moreover, it comes at a time when there are signs that inflation is cooling. Recent inflation readings for the Consumer Price Index and the Personal Consumption Expenditures Index have eased, import prices are falling, and inflation expectations are moderating.

Powell’s speech contrasted with his message at last year’s Jackson Hole symposium, when he predicted surging consumer prices were a “transitory” phenomenon stemming from supply chain-related issues. It has since become clear that an increasing portion of today’s inflation is demand-driven and therefore likely to persist for longer.

In the bond market, expectations for the pace of rate hikes did not change much after the event. Short-term yields had already built in the likelihood of a rise in the federal funds rate to 3.75% over the next six months. Thirty-year Treasury bond yields declined because tighter Fed policy for longer sends a signal of slower growth and lower inflation down the road. Consequently, the Treasury yield curve (the difference between short and long-term rates) became more inverted.

For the next policy meeting, scheduled for the 21st September, the market is pricing in a 100% chance of another rate increase. The only question that remains is whether it will be 50 basis points, to which the market currently attributes a 43.5% chance, or 75 basis points (56.5% chance). Beyond that, the Fed meets again in early November, one week before the mid-term elections, which has traditionally been associated with a period of inaction for the central bank. However, it may be different this time round given the hawkish tone of the Fed.

That leaves mid-December as the last meeting of the year. If inflation at that point has continued to ease, the Fed may still not need to raise at that point. But even if they do, there is a good chance the central bank can shift to a neutral policy stance and let data drive the decisions from meeting to meeting. That data is trending in the right direction. Inflation appears to have peaked, and future increases will become harder to come by as we begin to lap last year’s high readings. Energy prices should also calm down in the milder autumn weather, continuing the relief we have already seen in the US at the pump.

Inflation is not gone, and it won’t be gone for a long time. But consumers are still spending, even if more selectively, and the job market remains healthy. If inflation continues to cool down, the market should again look ahead to the end of rate increases, to the relief of both bond and equity markets.

Disclaimer: This article is brought to you by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd, which is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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