So the Fed has indeed rewritten close to three decades of precedent and set overnight lending rates 0.75 percentage point higher . . . the biggest tightening move since 1994. Wall Street isn’t really cheering, but there isn’t a lot of urge left to keep selling, either.
At this stage, we all recognize that inflation is eating the world alive. The Fed has wrestled prices into submission in the past using these tools. History demonstrates that victory is possible.
But history also demonstrates that the process is painful. Back in 1994, as we’ve discussed, stocks went nowhere for the entire year as investors digested the way the rate environment was evolving and opted to stick to the sidelines until the cycle swung back in their favor.
Interest rates are a drag. They make it harder for corporations to borrow money for growth or simply to float their operations through a slow season. And because higher rates make it harder for consumers to spend beyond their current income, retail activity and mortgage underwriting slows down as well.
Consumers and corporations alike are already reeling from two years of watching every dollar buy less day by day. We’re already feeling that drag . . . the drag of an economy running too hot for comfort.
The hope is that artificially raising interest rates to create a second source of drag will cool the economy down enough to kill heat-based inflation once again. After that point, the Fed can ease up and everyone can feel the relief.
We just have to reach that point first. Inflation needs to recede to levels we can tolerate . . . and then the Fed will relax.
In the meantime, adding the Fed’s drag to inflationary drag doubles the pressure on the economy. We’ll see growth slow down as every transaction starts costing even more.
The only question is whether that slowdown is going to be severe enough to send economic growth into reverse. The Fed currently says no.
By the end of this year, the economy should be 1.7% bigger . . . not great, but that’s in real terms, after inflation. We’ve all lived through long cycles of no inflation and 1.7% headline growth, so this might not feel great, but it’s definitely something Wall Street can work with.
The growth target is a step down from what the Fed saw in March, but then again, inflation is also tracking a step higher.
Three months ago, the Fed thought they could wrestle prices back onto a 4.3% annualized trend . . . again, not great, but it cuts the current inflation rate in half. Now they’re thinking we’ll have to stomach about 5.2% higher prices by the end of this year, which cuts about a percentage point off real growth.
That changing dynamic forces the Fed to get more serious. Back in March, they were thinking they’d have to raise overnight interest rates to 1.9% . . . now they’re committed to taking the short end of the curve all the way to 3.4% by the end of this year and roughly another half point up next year before relaxing.
At that point, inflation will be back below 3% if everything goes well. Will it hurt? The Fed currently thinks unemployment might revert to 4% in this cycle.
That’s higher than it is today, but it’s also where we all were in late 2017 and early 2018. It felt pretty good back then. Anything more serious will probably get the Fed to rethink.
But for now, the big numbers are still pointing to a relatively soft landing. After all, as the Fed notes, a lot of the inflationary pain right now isn’t even a factor they can control.
The Ukraine situation is putting upward pressure on the cost of food, fuel and fertilizer. COVID is disrupting supply chains in China. These are inflationary factors because major sources of supply of key materials are offline . . . but they won’t last forever. When they ease, the Fed can relax a little.
For now, their baseline scenario is not apocalyptic at all. The market evidently agrees.