The Fed’s next move

Markets summary

After months of laying the groundwork for a steady and substantial tightening in monetary policy over the next year, the Federal Reserve now faces a sudden change in the economic outlook.  As recently as mid-February, financial markets were pricing a 90% chance that the Fed would hike the fed funds rate by 50bp later this week.  Fast forward by a month, the picture is today far more complicated.  

The outbreak of war in Ukraine and subsequent economic sanction on Russia have caused a surge in commodity prices, due to the prospects of reduced supplies flowing to the markets.  The result has seen inflation rise to its highest levels in over 40 years.

However, while these supply-side shocks are exacerbating already high inflation, they also can slow growth down the road.  Moreover, this crisis is global in scale, and involves intense efforts to cut Russia’s access to the global financial system, which could put stress on Europe’s financial system.  The unknown consequences of these factors make the actions of the US central bank important to the international economy as well as the US economy.

Given all these uncertainties, expectations about the path of Fed policy have swung wildly in the past few weeks.  Two-year Treasury note yields, which largely reflect expectations about the path of the federal funds rate over the next few years, have traded in a huge 35-basis-point range since the outbreak of the Ukraine war.

Past price shocks have tended to produce two outcomes: higher inflation and slower growth.  The US economy has suffered through oil price shocks in the past – especially during the 1970s oil embargoes.  The result was a period of stagflation and recessions.  More recently, oil prices have seen periods of large increases in the mid-2000s without necessarily triggering recessions.

Today, the US economy is less sensitive to rising energy costs than in the past due to the rise in domestic production, shift to other fuel sources, and increasing efficiency in energy usage.  Nonetheless, surging energy costs can slow economic growth by acting as a tax on consumer incomes, reducing business investment, and eroding consumer confidence and spending.  

Fortunately, the US economy has been growing at a strong pace, which should help soften the blow to economic growth from higher energy costs.  All this has however also exacerbated an upturn in inflation, spurred by supply shortages coming out of the pandemic and strong consumer demand.

In recent congressional testimony, Federal Reserve Chair Jerome Powell indicated that the central bank still planned to raise short-term interest rates by 25 basis points at this mid-week meeting.  However, most market participants now believe there is a good chance that this will be a slower and shallower rate-hike cycle than previously anticipated, due to the potential for slower economic growth, easing inflation later in the year, and tightening financial conditions.

Despite the recent spike, there is still a good chance that inflation could ease later in the year as comparisons to a year-ago readings level out, waning fiscal stimulus slows the pace of consumer demand, and tighter monetary policy tightens lending conditions  There are already signs of a slowdown in housing activity due to rising mortgage rates and business inventories rising relative to new orders.

In conclusion, although members of the Federal Open Market Committee would like to pursue a steady path to raising short-term interest rates and reducing its balance, it may not be as easy as they might have expected just a few weeks ago.  This could make the Fed move more cautiously in the months ahead, with four to five rate hikes this year.

 

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

For more information visit https://cc.com.mt/. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.