Market stress may force the Fed to slow the pace of rate hikes

The Federal Reserve remains adamant on bringing core inflation down to 2%. In its latest projections, the Fed sees the federal funds rate moving up to an average range of 4.6% by early next year from its current 3.25%. Fed Chairman Jerome Powell has even acknowledged that this may eventually lead to some pain, which in economic terms should translate to no more than a mild recession.

However, in recent weeks the possibility of a more serious accident has emerged: the risk that the Fed’s aggressive tightening will not just tip the US into recession, but potentially destabilise the financial system in the process. Volatility has spiked up in recent weeks in a range of markets, from currencies to bonds, raising concerns about the ability of the global economy to cope with sharply higher US interest rates. If these trends continue, the Fed may be forced to moderate its pace of tightening by considering smaller rate hikes.

The Fed, like many other central banks in advanced economies, was late to start tightening, allowing inflation to rise, but it has made up for lost time since its initial rate hike in March 2022. Following that, the federal funds rate has moved up by 300 basis points at an accelerating pace. In fact, on a rate-of-change basis, this is the fastest rate-hiking cycle in modern history.

Given that monetary policy works with a lag, the impact of rate hikes is just beginning to work its way through the economy. Evidence of that is the slowdown in economic growth, led by a weakening in housing and manufacturing. However, more important is the trend in leading economic indicators, captured by the Conference Board’s index, which is down for the sixth consecutive month. Moreover, commodity price inflation has fallen sharply from peak levels and service sector pressures are starting to ease.

The troubling development in recent weeks is the spike in volatility across many financial markets. The dollar has surged to new all-time highs, driven by a combination of relatively high US yields and safe haven demand amid global political turmoil. The strong dollar has a positive impact on US inflation in that it makes imports less expensive but it also slows growth by making exports less competitive and thus more expensive for its trading partners.

However, there are potential negative effects that could spill back onto the US economy as well. Foreign central banks have had to hike interest rates to stabilise their currencies and inflation, which usually involves selling US Treasuries. Even the Bank of Japan, which has welcomed higher inflation, intervened in the market to support the yen recently because it had fallen so rapidly.

Moreover, since the dollar is the world’s reserve currency and is used in the majority of global transactions, a rapid rise can increase the cost of borrowing globally, particularly in emerging markets where companies and countries have borrowed heavily in US dollars. Servicing those debts and paying the capital back with a currency that has fallen in value raises the risk of defaults.

Stress is also evident in the Treasury market, where volatility has risen to levels previously seen during periods where financial institutions have had trouble transacting easily. The last episode was at the start of the pandemic in March 2020, which resulted in the Fed stepping in to provide more reserves to the system. Consequently, the risk premium demanded by financial institutions and investors in the fixed income markets is rising.

In conclusion, while the Federal Reserve is not expected to stop hiking rates any time soon, a case is starting to build that market pressures may force it to slow the pace. By accelerating the pace of its rate hikes, the Fed has laid the groundwork for lower inflation but also raised the potential for global financial markets stress that could derail economic growth.

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, which 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.