On September 21st, the Fed delivered another aggressive rate hike of 75bp, taking the target rate to 3% to 3.25%, the highest since before the financial crisis.
Despite being widely anticipated, stock and bond markets appeared unsure how to respond, gyrating in the following hours. The S&P500 finally closed down 1.7% over the day.
The overall negative response by risk assets to the announcement reflected the Fed’s revised economic and interest rate expectations. It has sharply downgraded GDP growth forecasts (from 1.7% to just 0.2% this year and 1.7% to 1.2% in 2023). This will impact corporate profits.
On interest rates, the message was ‘higher for longer’. The accompanying dot chart of rate predictions from the Fed policy committee not only suggested yet another 75bp rate hike at the next meeting but also that rate hikes are not expected to end until late 2023, by when the Fed fund rate may be around 4.6%.
Before the announcement, the market consensus had been for a rate cut to have begun by the end of 2023.
There is a sense that the Fed is determined to make up for lost time after having sat on its hands last year as the first signs of inflation emerged.
Why raise rates when headline CPI inflation is rolling over?
The Fed’s preoccupation is not with the headline rate but with core inflation (i.e., excluding food and energy). High energy inflation acts as a tax on discretionary spending and so is a deflationary force in the medium term. The Fed, along with other central banks, has made clear it can, in any case, do little to tackle high energy costs.
But August’s inflation report showed core CPI continuing to rise, fuelled by strong demand for goods and services prices. This reflects strong wage growth (of around 6%), low unemployment, and the spending on furlough payments, which are all contributing to robust household demand.
The risk of embedded inflation lies here: pay rises to push up prices, leading to demand another pay hike, and so on. The Fed wants to weaken the labour market to prevent such a cycle from developing. 6% wage growth will not deliver the Fed’s target 2% inflation!
Powell warned at the press conference of the dangers of ending rate hikes prematurely, echoing comments made last week: ‘higher credit card bills and job losses hurt, and weaken the economy. But they are not as painful as failing to achieve price stability and returning with more rate hikes.
The aggressive stance of the Fed will persist. How stocks respond will depend very much on the level of demand destruction required to weaken the labour market, i.e., on the extent of the coming slowdown in the economy. That is the big unknown, but it does appear likely that over the coming six months, defensive sectors, such as consumer staples, financials and utilities, may outperform growth-sensitive sectors such as tech and consumer-discretionary sectors such as luxury goods.
As core CPI starts to respond to the higher interest rates, which it must surely do over the next year, we should see long-dated Treasury yields start to fall (and their prices rise). However, we may suffer a further jump in yields if core CPI remains stubborn.
It is hard to invest in an environment of stagflation. Investors should remain diversified by asset class type and by region and avoid making strong bets.
The strong dollar is other people’s problem
The dollar will continue to benefit from the aggressive stance of the Fed. But because of the relatively closed nature of the US economy, it will not have much impact on American inflation (a strong currency is usually deflationary, as imports will cost less).
Rather, countries that import dollar-priced commodities and goods feel the effects of higher import prices on their economy.
Sterling fell further on the Fed’s announcement today, to $1.13. A victim of the increased gap between dollar and sterling interest rates, and of scepticism by currency traders of the new team at the top of the UK government.
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