The Good News and Bad News in Today’s Fed Move

Will it be 50, 75 or 100? In the run-up to Wednesday’s Federal Open Market Committee rate decision and presser, that was the debate. Not whether they would hike, but by how much—50 basis points (bps, or 0.50 percentage point), as Fed Chair Jerome Powell intimated in May? Or would they be more aggressive, aiming to tighten policy in an effort to cool inflation? In the end, they opted to go bigger, hiking rates by 75 bps—the biggest single hike since 1994. With the S&P 500 entering a bear market earlier this week (breaching -20% from January 3’s high), many now fear the Fed erroneously and aggressively tightening against this backdrop means a recession is coming. While we understand that logic, it seems like a hasty conclusion, in our view. Let us explain.

First, while this downturn is now officially a bear market, it still looks mostly sentiment-driven to us. An unusually wide array of worries has taken turns dragging markets lower this year. Inflation. Putin’s vile Ukraine invasion and fears of wider war. Oil, commodity and other goods shortages. Chinese lockdowns. Eurozone economic weakness. Political worries. All have, at times, dominated discussion—unlike typical downturns, which generally feature one or two fears.

But after last week’s US consumer price index acceleration surprised many pundits, worries of hot inflation triggering an even more aggressive Fed returned to the fore. Some, as today’s Q&A with Powell suggested, even think the Fed is trying to induce a recession to slow rising prices. (A notion the Fed Chair repeatedly rejected.) These fears stoked big swings last Friday. And, on Monday, market-based expectations shifted swiftly toward a 75 bps hike and stocks tumbled below the -20% threshold that technically marks a bear market.^[i] Now, to be clear, there isn’t anything about rising rates—whether short or long—that automatically dooms stocks. The relationship is vastly overrated. But it does seem to have roiled sentiment, especially as some alleged the upturn in expectations was based on leaked information emerging during the Fed’s media blackout period. Regardless, Treasury yields jumped, pricing in the rumored action, with 3-month yields rising from 1.26% last Tuesday to 1.83% yesterday, on the cusp of today’s announcement.^[ii] 10-year yields similarly rose from 2.98% to 3.49%.^[iii]

This is likely why markets didn’t react much to today’s “surprisingly” big hike, with both 10-year and 3-month yields falling slightly after the release. It also helps explain why we don’t see the move as problematic for the economy. At 165 bps now, the key 10-year minus 3-month Treasury yield spread is just under where it was at May’s end. It has widened this year, too, despite the Fed now hiking the fed-funds target rate by a total of 150 bps in the last three months. That is important, considering banks borrow short-term to fund long-term loans, rendering the spread a key indicator of future loan profitability and, hence, availability. This is why the yield curve is such a useful tool to weigh future growth. We are aware of no research showing such steep yield curves precede recession. Materially inverted curves—when short-term rates top long—often do. But we are a far cry from inverted today.

So we don’t think today’s move constitutes a major error changing the likelihood of recession much. But for those hopeful the Fed’s moves will slow inflation, we have a few cautionary words. For one, we are still chiefly dealing with supply-driven issues inflating prices. In his press conference, Powell even outright mentioned that although the Fed targets headline prices, there isn’t all that much the bank can do to lower oil and food prices, which are driven principally by commodity-market factors. However, you can apply that same logic pretty broadly, roping in things like semiconductors, used cars and more. Monetary policy mostly affects growth very indirectly, through adjusting credit markets and, therefore, demand.

Two, as we noted recently, monetary policy tends to hit at a lag of undetermined length. Now, the Fed seems rather impatient to see slowing inflation stemming from its hikes, as Powell noted that the fast pace lately is an effort to “front-end load” hikes, aiming to see “compelling evidence” of slowing prices. Powell further cited both the May CPI reading and inflation expectations’ upward creep as underpinning the move. But again, theory doesn’t support the idea you can move the needle on inflation in around two months. Even to the extent rate hikes can cool this inflation, we wouldn’t expect to see it yet.

So fundamentally, we don’t think this week’s Fed drama changed all that much. It did roil sentiment, in our view. And it added some intrigue around whether the Fed deliberately leaked its plans to the Wall Street Journal in some weird kind of last-minute jawboning. But the yield curve is just as steep now as it was a week ago, which suggests to us credit markets are healthier than many appreciate and a recession likely isn’t at hand. And inflation isn’t likely to immediately cool.