The U.S. Federal Reserve has raised interest rates by 0.25% and the signs point to more tightening in the pipeline, according to Silvia Dall Angelo, Senior Economist at Federated Hermes.
Dall Angelo said going into the Fed’s meeting, the conflict in Ukraine had complicated the already tricky growth-inflation trade-off central banks were facing, yet inflationary concerns have remained dominant for the Fed.
“While war-related uncertainty will ensure some caution going forward, increasingly pervasive domestic inflationary dynamics in the context of a tight labour market point to more tightening in the pipeline,” she said.
“The updated dots shows the Fed now expects six more rate hikes this year, i.e. a 25bp rate increase at every meeting over the balance of 2022. In addition, the dots plot suggests that most FOMC participants now see a restrictive monetary policy stance as appropriate by the end of 2023.
“While the significance of the dots is somewhat reduced due to war-related uncertainty, hawkish expectations on rates are justified by the updated growth and inflation projections showing a pronounced worsening of the inflation picture compared to December. Growth forecasts were adjusted down only moderately in the very short-term, as US economic activity is fairly insulated from the consequences of the war in Ukraine at it stands – crucially, the US is energy independent, meaning that its economy has low sensitivity to changes in energy prices.
“By contrast, inflation is now expected to remain elevated throughout this year, with the recent surge in energy price pushing the much-awaited downward inflection point further out into the future. The Fed is well aware of the risk of a price-wage spiral: the longer inflation remains elevated, the higher the risk it becomes embedded via expectations and wage formation dynamics. And recent developments across inflation and labour market indicators already point to some emerging second-round effects.
“Nonetheless, while the Fed is sounding hawkish, it is not a given that action will follow in short order. As geopolitical uncertainty looms large, the Fed will likely continue to be somewhat reactive rather than proactive with respect to inflation developments. The Fed cannot control cost-push price pressures stemming from the latest exogenous shock, hence it has little control on the drivers of the latest inflation surge.
“However, it will continue to be alert to indications inflationary dynamics are becoming embedded via expectations and/or the labour market. The war in Ukraine, the evolution of the growth-inflation trade-off and indications concerning second round effects for inflation, will dictate the pace of tightening going forward.”
Specialist investment managers from global investment firm Franklin Templeton Group has also weight in on the change.
Sonal Desai, CIO of Franklin Templeton Fixed Income:
I am surprised that the hiking cycle is as short as it appears to be. In addition, the terminal rate has not changed at 2.8%, which means we will end the hiking cycle with real rates barely positive (using Fed’s own forecasts). Not clear what actually brings inflation down as quickly as is anticipated given this.
Bill Zox, CFA, Portfolio Manager, Brandywine Global:
“The Fed does not seem concerned about interest rate volatility or the recent declines in financial assets. The Fed dot plot for the next year or so did roughly match what financial markets were discounting. It seems to me that the Fed is leaving it to financial markets to dictate the path of the fed funds rate. That approach will lead to more interest rate volatility than if the Fed were engaged in more of a two-way interaction with the financial markets. I suspect that incoming economic data will be volatile and the financial market reaction to that data will also be volatile. So my sense is more of the same for financial markets until the data suggests that inflation is coming back down. If investment grade bonds, high yield bonds and stocks do continue to decline, we may find out when the Federal Reserve is willing to get more involved in a two-way interaction with the financial markets.”
Patrick S. Kaser, CFA, Managing Director & Portfolio Manager, Brandywine Global:
“The Fed release today is unsurprising – they are clearly on a path to higher rates, which the bond market at least seems to recognize. The equities market appears more uncertain about the balancing act between inflation, geopolitics and economic growth, and the range of views among investors is quite wide. We believe that for now, at least, the Fed needs to signal it is willing to fight inflation, and it can make adjustments to the pace of hikes in the coming months as developments warrant.”
Josh Jamner, Investment Strategy Analyst, ClearBridge Investments:
“The Federal Reserve kicked off a tightening cycle today, raising the Federal Funds rate by 25 basis points, consistent with market expectations. The “Fed Dots” or Statement of Economic Projections, also came in consistent with market pricing for the total number of interest rate hikes this year, at six to seven or a nearly 2% Fed Funds rate. Chairman Jay Powell commented during his press conference that inflation is likely to remain higher for longer and economic growth to come in slower given supply chain entanglements and commodity price increases emanating from the Russia-Ukraine situation.
“The dots suggest inflation cooling to 4.3%, an increase from 2.6% shown in December, and GDP growth of 2.8% vs. 4.0% in December. Of note, the dots suggest the Fed will increase rates further in 2023 but then stop, with inflation cooling but remaining modestly above 2% even in 2024. Chair Powell left the door open to moving more quickly in terms of tightening monetary policy if needed and suggested the committee had not yet decided the path of tightening this year in terms of front-loading rate hikes or adopting a slower and steadier approach throughout the year.
“Financial markets digested this information well with equities rallying, long-term interest rates remaining largely stable, inflation expectations dropping and credit spreads narrowing. Given that the Fed’s actions were largely expected and no major surprise occurred, a positive market reaction is a welcome development.
“Powell also suggested that balance sheet run-off, or quantitative tightening (QT), could begin as early as the next meeting (May). QT will serve as an additional step to tighten policy and Powell suggested that the implementation would look familiar to the balance sheet run-off that occurred in 2017-2019, although there would likely be a faster pace given the larger size of the balance sheet itself.”
