As anticipated, the Fed raised its federal-funds rate Wednesday by half-point and said it would like to start unwinding its portfolio of longer-term securities.
In March the central bank raised interest rates for the first time since the beginning of the pandemic recession, when it moved the funds rate from zero to 0.25%. Wednesday’s half-percentage point hike was the first rate increase of that magnitude in 22 years, and it was accompanied by a serious warning of more to come.
With Fed chair Jerome Powell having indicated as recently as late April that a half-point increase was almost certain, the question on many investors’ minds was, ‘What happens next?’ Was the Fed going to accelerate the pace of rate increases even more to fight persistently elevated inflation?
Bond markets had been pricing in the Fed gearing into very high territory in recent days, with expectations rising for a 0.75 percentage point hike in the June meeting. The Fed hasn’t lifted rates that high since 1994.
Speaking at a press conference after the meeting of the policy-making Federal Open Market Committee, Powell poured cold water on that scenario.
“There’s a broad sense that, at the next couple of meetings, an additional 50 basis points should be on the table,” Powell says. “Seventy five basis points is not something we are actively considering.”
It was a relief for bond and stock markets, which rallied after the Fed decision.
Still, there is no doubt that rate hike expectations have bounding higher in the weeks leading up to the committee's meeting, which the Fed has corroborated with a record of support for a series of 50-basis-point hikes through the balance of this year. Futures markets suggest that the rate, known as the fed funds rate, will reach 3.25 percent by the first three months of 2023, its highest since 2007.
Bond markets have priced in these rate-hike expectations, so yields have soared. That means the Fed’s hawkish turn is already beginning to take a toll on the economy. The big misconception about monetary policy is that the tightening is simultaneous with rate hikes. Instead, tightening takes place when expectations for future rate hikes have already been factored into bond yields, which is what has happened in the past several months. That’s most because most borrowing at play in the economy isn’t based on the federal-funds rate (the shortest term interest rate), but longer-tenured yields.
In fact, the rate on a 30-year mortgage has spiked above 5 percent, its highest in more than a decade, compared with roughly 3 percent. As a result, there has been a sudden death of housing affordability, which will most likely have a heavy weight on demand many moons ahead. Consequently, we recently downgraded our 2023 housing starts forecast to 1.45 million, which would mark a 10% reduction relative to 2022.
Quantitative Tightening and Long-Term Yields
A big question is how much further long-term bond yields might rise, particularly now that the Fed is preparing to begin shrinking its portfolio of long-term securities that it accumulated as part of its quantitative easing program. The Fed will allow assets from its $9 trillion balance sheet roll off when they mature, to a maximum pace of $95 billion in net asset sales per month as of September 2022.
Bond markets have had ample opportunity to prepare for this forthcoming “quantitative tightening,” though the size of the Fed’s sales suggests additional yield rises may be in store. We doubt the Fed will allow its asset sales to drive yields to unreasonable levels, but clear guidance on this topic has been lacking.
Economic Recovery and Inflation Pressure
Persisting strength in the economic recovery removes impediments to the Fed pursuing a policy of aggressive monetary tightening. The unemployment rate is already pretty much back to its pre-pandemic level, while the employment-to-population rate isn’t far behind with the labor force participation rate starting to make a recovery. Sans the noise, the 1.4% decline in first quarter U. S. real gross domestic product surprises to the downside, in our view, as underlying spending continues to expand.
Instead, the news from recent months has bolstered support for the Fed’s argument to tighten policy so that it can combat inflation. Headline CPI gain jumped to 8.6% YoY in March on the back of soaring oil prices. A complete embargo on Russian oil was recently one step closer to becoming a reality for the European Union, which will not help relief from oil prices. And a tightening lockdown in China poses the risk of more disruption to global supply chains.
Mirroring how much the rise in inflation has become a front-page issue, Powell opened the press conference with remarks directed at the public in a rare move. “Inflation is way too high, and we know the pain that it’s causing, and we’re acting expeditiously to bring it down,” he said.
