Fed Hikes Rates by 75 Bps Again

As was widely expected, the Federal Reserve voted unanimously yesterday to increase short-term interest rates by 75 basis points for the second consecutive meeting. This brings the Fed Funds target range to between 2.25% and 2.5%. The initial market reaction to the rate increase was muted, but equity markets rallied strongly during Fed Chair Jerome Powell’s subsequent press conference. The S&P 500 rose 2.6 percent on the day and the NASDAQ rose more than 4 percent. We believe that markets initially interpreted some of Powell’s early comments as dovish, or at least as less hawkish than feared. However, we think this interpretation ignores the fairly hawkish comments made later in the press conference.?

Based on its timing, the market rally was seemingly fueled by the Fed Chair suggesting that policy decisions moving forward would be made on a meeting-by-meeting basis. He also characterized the current level of interest rates as roughly neutral and stated that the committee believes they will need to increase interest rates until they are “moderately restrictive.” Together, these comments imply that the tightening cycle has progressed to a new stage and that end of the tightening cycle is perhaps closer than previously believed. While we agree these comments are dovish, we think the market reaction ignored the more hawkish comments that followed.

First, Powell consistently referred to the prevailing strength of the labor market to support his contention that the US is not currently in a recession. We agree. Over the last three months, nonfarm payroll gains have averaged 375,000 and the unemployment rate in June was just 3.6 percent. Powell also acknowledged that spending and production growth is slowing. In its policy statement, the FOMC noted that spending and production have “softened”. We take this to mean that policymakers plan to weigh labor market conditions more heavily than other data when evaluating how policy is impacting the economy. The policy statement reiterated once again that the committee is “highly attentive to inflation risks”, and we expect that will continue to be the case until either inflation falls significantly or labor market conditions deteriorate.

Furthermore, Powell went on to say that the non-accelerating inflation rate of unemployment (NAIRU) has likely risen post-pandemic because of new issues with employer-employee matching. This means that unemployment could rise significantly from the current 3.6 percent level before policymakers would take steps to support the labor market. Taken together, we interpret these comments to mean that the potential ceiling for interest rates is higher than the market currently expects.?

Powell also said that the Summary of Economic Projection released following the meeting last month remained a good indication of the committee’s expected path of monetary policy tightening. Those projections showed that the median expectation for the level of the Fed Funds rate was 3.4 percent at the end of this year and 3.8 percent at the end of next year. In both cases, this is more hawkish than the current market expectation of 3.3 percent and 2.8 percent, respectively. If the Fed still has credibility with markets, we may see the interest rate expectations move higher, which would be a negative development for equity markets valuations.

We agree with former Fed official Bill Dudley who said of Powell’s statements during the press conference, “I really didn’t hear his comments as dovish.” Indeed, Powell himself suggested that though monetary policy risk is two-sided, the risk of the Fed doing too little to fight inflation is greater than if they do too much. We expect policymakers will err on the side of doing too much when making policy decisions through the end of this year and into next year. Ultimately those decisions will depend on the incoming data. There are eight weeks until the next FOMC meeting, two weeks longer the normal, and policymakers may be confronted with a very different set of economic circumstances when making their next policy decision.

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