The Fed has raised interest rates for the first time since December 2018, as inflation continues to run hot and the unemployment rate continues to fall. The war in Ukraine and the resulting energy price shock makes the path of policy highly uncertain from here.
As expected, the Federal Reserve’s Open Market Committee (FOMC) delivered a 25 basis point (bps) increase to its target fed funds rate range, the first time it has done so since December 2018. The new target range of 0.25% to 0.50% is obviously still quite low on a historical basis, but all indications are that it will move steadily higher over the balance of the year.
The Fed came into this meeting facing some unexpected challenges, specifically the uncertainty created by Russia’s invasion of Ukraine. The FOMC’s statement pointed out that the invasion could “create additional upward pressure on inflation and weigh on economic activity.”
The Fed also released new economic and interest rate forecasts, which now show growth slowing to 2.8% this year and core inflation running at more than double the Fed’s 2% target in 2022. Importantly, the median forecast has inflation remaining above that target in 2023 and 2024, leading the path of interest rate increases to continue well into 2023 and stop at a higher terminal rate of 2.75%.
Fed no longer in the driver's seat
While financial markets spent most of January and early February hanging on every word uttered by an FOMC member, the situation in Ukraine has overtaken monetary policy as the markets’ primary focus. The Fed now has to gauge the economic impact of sharply higher energy prices – without knowing how long they will last – as it calibrates the proper path for interest rate hikes from here.
As he has done in his press conferences following recent meetings, Fed Chair Jay Powell emphasized the need for policymakers to remain humble as they grapple with multiple uncertainties, from the resolution of the war in Ukraine to the shifts in consumers’ economic behavior coming out of the pandemic. The “dot plot” of individual members’ interest rate forecasts shows considerable dispersion in 2022 and beyond. Even so, Powell hinted that the reference in the statement to the Fed reducing its balance sheet “at a coming meeting” could mean as soon as the next one in May.
What is certain? Inflation continues to run hot and the labor market has tightened, calling for higher interest rates. Just how high will depend on the war’s resolution (if there is one) and how quickly inflation fades over the summer (if it does). Neither of these seem to reside within the Fed’s power to forecast, let alone control.
Implications from the war in Ukraine
The clearest immediate effect of the energy price shock emanating from the war in Ukraine will be on consumer price inflation, which increased 0.8% in February and 7.9% over the past year. This was before the bulk of the sharp move higher in gasoline prices had occurred. In March alone, so far, U.S. gasoline prices have risen just under 20%, which implies a 0.75% contribution to this month’s inflation from just this one category. We see headline inflation breaching 8% and flirting with 9% year-over-year before coming down in the late spring and summer. The effect on core inflation, which excludes food and energy prices, should be more modest. We see a similar peak and decline in this measure over the coming months.
We are more concerned about the impact of higher commodity prices on economic growth, specifically consumer spending. As households pay more at the pump, they may spend less on other goods and services. Consumption was already set to soften this year in the absence of federal stimulus, particularly for lower-income households that have already spent much of the savings they accumulated in 2020 and the beginning of 2021. On the plus side, energy costs account for a smaller wallet share than they did during the 1970s crisis, meaning a price spike should not have as pronounced an effect. So while we have downgraded our expectations for U.S. GDP growth for 2022, we do not see stagflation on the horizon and expect a solid economic expansion of 2.5% to 3%, similar to the Fed’s forecast.
Rates still heading higher from here
While Treasuries rallied initially in a flight to safety as Russian tanks crossed the Ukrainian border last month, rates have since marched straight back up to their mid-February highs. Market-based expectations for the Fed are for six to seven additional 25 bps rate hikes over the remaining six meetings in 2022. In an ideal scenario – one in which exogenous events do not derail the Fed’s plans or the broader economy – we see the Fed hiking once per meeting into early 2023 and stopping around its estimate of the neutral range of 2.25% to 2.50%. The Fed believes it will need to hike by more, with the median “dot” expecting a total of seven hikes this year and another three to four in 2023, moving monetary policy firmly into “tight” territory.
If the Fed hikes by less than this, it’s likely because growth and inflation are slowing more quickly than expected. If it hikes by more, then inflation has failed to subside and monetary policy is struggling to keep up. Neither of these would be especially friendly scenarios for equity and credit markets, but the medium “Goldilocks” scenario should see spreads tighten and stocks bounce. In that scenario, longer-term interest rates should rise further, allowing the 10-year U.S. Treasury yield to end the year around 2.5%.
A final thought on the yield curve
Close followers of the Treasury market will know that a flatter yield curve, which occurs when the yields on short- and long-term bonds converge, is often a harbinger of slower growth. Right now, the curve is flat, and, as we noted earlier, growth is set to slow from its torrid 2021 pace.
But the drivers of the flatter yield curve are different today than they were prior to the last two recessions. Near-term inflation expectations have risen to their highest levels ever, leading investors to demand higher yields on shorter-term fixed income (expectations for higher rates from the Fed are also contributing to this). Investors see inflation fading, eventually, so they’re demanding less of a premium on longer-maturity bonds. Stripping out inflation expectations, the real Treasury curve has remained quite steep by historical standards. In other words, the bond market does not fear the Fed will err and tip the economy into recession. Neither do we.