Our Take on the Fed’s Half-Point Hike

Wednesday, as widely expected, the Fed raised the fed-funds target range by half a percentage point to 0.75% – 1.0%, its first rate hike larger than a quarter point since 2000. It also confirmed it will start letting assets roll off its balance sheet in June, starting at a cap of $47.5 billion per month and jumping to $95 billion in September—basically following the blueprint unveiled in March’s meeting minutes. And for the first half hour or so, stocks did about what you would expect when there is no big news: a whole lot of nothing, waffling between small gains and small declines. But then the S&P 500 jumped—apparently as Fed head Jerome Powell said the Federal Open Market Committee isn’t “actively considering” a 0.75-point hike. Never mind that he also said “additional [half-point] increases should be on the table at the next couple of meetings”—evidently, what everyone really cares about is a three-quarter-point move. It is all quite arbitrary, yet it is also hard to complain, considering the late surge put the S&P 500 up 2.99% on the day.^[i] But also, if this doesn’t prove investors are irrationally obsessed with the Fed, we aren’t sure what would.

We still think stocks are likely to do well this year despite the early correction (sharp, sentiment-fueled drop of -10% to -20%), so we would love to tell you that Powell’s remarks helped reduce uncertainty and the clarity created some massive bullish tailwind. But, dear readers, experience tells us that would be a load of codswallop. If we were to jump on that bandwagon, we would implicitly argue Fed forward guidance actually predicts Fed moves. (It doesn’t.) And that Fed people always do what they say they will do. (They don’t.) We would also be making an argument that the speed and magnitude of rate hikes in this context matters, as if there is some meaningful distinction between, say, raising rates half a point at each of the next few meetings and sneaking a 0.75-point hike in there at some point. Or, if the Fed hiked half a point each in June, August and September and, say, an additional quarter point in October, that is mathematically the same as hiking half a point in June and August and 0.75 point in September. The Fed doesn’t have some big cartoon lever with a bright red “danger zone” warning at the 0.75 percentage point marker. As we write, the gap between 3-month and 10-year yields is still a mite over 2 percentage points.^[ii] What matters is whether the Fed inverts the yield curve, not the path they might take en route to that error. Whether they do it with a handful of major hikes or with 17 straight quarter-point hikes, as they did in the mid-2000s, the result would be the same. 

Some observers argue it isn’t the rate hike plans themselves that soothed sentiment, but rather the implication that inflation won’t be bad enough for long enough to warrant the first 0.75-point hike since 1994 (after which, we would add, the S&P 500 soared 31.2% over the next 12 months).^[iii] Well, ok, but that is tantamount to arguing the Fed is a brilliant economic forecaster that manages inflation perfectly. But these are the same folks who thought deliberately flattening the yield curve with quantitative easing would stimulate the economy after 2008’s financial crisis, and couldn’t fathom why their GDP forecasts proved too optimistic. The same folks who were dead sure the right choice in 2008 was to mystify investors and markets by forcing Lehman to fail.^[iv] The same folks who are now trying to control supply and energy shock-induced inflation by slowing money supply growth. Newsflash: If inflation isn’t caused by monetary factors, then monetary measures aren’t likely to fix it.

We have long thought people are just too obsessed with the Fed, as if the crew at 20^th and Constitution has massive amounts of control over the economy. Some in the financial press have a penchant for invoking metaphors of Fed officials steering the US economy or manning its helm. To call this overstated is, in our view, being generous. The US economy is far too big and decentralized for the Fed to have much influence outside of making an egregious error that causes a credit crunch. That is a risk you must watch for regardless of policymakers’ forward guidance.

But beyond that? At best, the Fed can influence money supply growth and velocity at the margins by the way their moves impact market-set rates. These days, because banks have a deposit glut, short-term rate moves have seemingly little means to impact lending, which is how most money gets created in our fractional reserve banking system. As you are no doubt painfully aware, banks didn’t pass the Fed’s first rate hike on to customers. Hence, they aren’t paying more to borrow. About all the Fed can do if it wants to tighten is hope its interest rate on excess reserves is enough to entice banks to park cash instead of lend enthusiastically. But considering their balance sheet runoff plans also promote a steeper yield curve—which means wider profits on new loans—we doubt that happens. Note that loan growth has accelerated sharply this year despite the Fed’s hikes.^[v]

The Fed is nothing to ignore. But, in our view, far too many investors imbue it with much more power to sway stocks and the economy over meaningful periods than it has. Yes, announcements can stoke the occasional short-term swing, including today’s pleasant rise. But overthinking them is an all-too-common error.