- March 23, 2022
-- After two years of holding borrowing costs near zero, the Federal Reserve took the first step toward normalizing its policy last week. The announced 0.25% rate hike was the first since 2018, the first liftoff from zero since 2015, and likely the first in a series of hikes over the next two years.
By the end of this tightening campaign, Fed officials expect to raise rates as high as 2.8%.1
Yet monetary tightening is not on a preset course. We suspect rate hike expectations will fluctuate along with the trajectory of economic growth and inflation.1. The Fed is on a mission to tame inflation
2. Policymakers pencil in a somewhat aggressive path for rate hikes
- The Fed would prefer to see inflation ease through growing supply and clearing bottlenecks. But they're no longer willing to wait for this to happen, fearing high price pressures might become entrenched. By raising the cost of money over the next two years, the central bank hopes to guide inflation down by slowing demand to align it with supply.
3. The economy no longer needs help
- Last week's Fed announcement leaned hawkish, in our view, with a rate hike at every remaining Fed meeting this year and the likelihood they'll begin reducing the central bank's almost $9 trillion bond holdings as early as May. Yet stocks rallied, which we would attribute to near-term oversold conditions, more clarity around the future interest rate path, and the fact that the bond market was already pricing in an aggressive tightening cycle.
4. Achieving a soft landing is no easy feat.
- Strong employment is supporting income, savings are high, and household debt relative to income is low. All this suggests consumers are in the best financial position they have been in years. And interest rates are expected to remain negative in real terms (after accounting for inflation) next year.
5. Stocks and bond yields have historically continued to rise during Fed tightening.
- Over the next three years, the Fed aims to bring inflation closer to its 2% target without slowing the economy too much. Historically, this has proved to be a challenge. The economy doesn't always end up in recession, but when it occurs, it happens about 2.5 years after the first hike.
Sources: 1. March FOMC, 2. Bloomberg, 3. FactSet, Edward Jones calculations
- Looking at the five tightening cycles since 1985, stocks have historically experienced some weakness around the first interest rate hike but generally maintained their upward trajectory six months and a year out.3 With valuations having already declined 18% so far this year, perhaps a lot of the adjustment has already happened, especially if we see the situation in Ukraine de-escalate and energy prices crest.2