March Fed Meeting and Rising Rate Expectations
The Federal Reserve has officially hit liftoff on short-term interest rates, and the ship could be moving faster and higher than previously expected.
The Fed’s decision on March 16 to raise the federal funds rate to a target range of 0.25%–0.50% represented its first rate hike in more than three years and while this policy was widely expected, we believe investors should take the following into account:
Fed members see higher than previously anticipated rates ahead. The Committee’s decision came accompanied by its highly anticipated quarterly dot plot, in which median Fed member expectations now convey federal funds rates of 1.9% by the end of 2022 and 2.8% by the end of 2023. This outlook represented a noticeably more hawkish tone from the Fed versus the most recent December 2021 dot plot when median year-end 2022 and 2023 expectations were materially lower at 0.75% and 1.50% respectively. In essence, this means the Fed has now pulled forward its rate-tightening cycle by more than a full year.
Balance sheet reduction could be fast tracked. In the post-meeting press conference, Federal Reserve Chair Jay Powell also indicated the Committee could begin reducing its nearly $9 trillion balance sheet of Treasury and mortgage-backed securities as soon as the upcoming May meeting. While precise details are not yet known, we expect the Fed to begin reducing holdings at a monthly pace of about $75–$100 billion, equating to approximately $1 trillion annually. Such balance sheet reduction should have a further financial tightening impact and will likely influence a continued rising path for longer-term bond yields. We also expect Fed balance sheet reduction to be implemented originally through maturing bond principal roll off before that of selling bonds in the open market.
Stocks react favorably. Anxiety over when and by how much the Fed would begin raising rates has plagued markets in recent months, however stocks rallied strongly following the Fed’s meeting. We mostly attribute this to the Fed’s hawkish tone representing a more urgent approach to fighting inflation, now at 40-year highs. It is our judgment at this point that the market is now more concerned about potentially runaway inflation than with a faster pace of rate hikes slowing economic growth.
Our judgment is the economy can absorb higher interest rates. While fears of recession are now being commonly expressed throughout the investment world, we believe the economy will likely be able to absorb the expected upward interest rate trajectory into CY 2023 and that gross domestic product growth can remain above 2% into next year as declining case trends of COVID-19 should spur pent-up consumer demand beginning in 2H 2022.
Inflation likely to remain hot. We expect inflation reports such as the consumer price index and the Fed’s preferred measure, personal consumption expenditures, to continue increasing into the summer months with headline readings on these metrics impacted by the ongoing war in Ukraine and rising energy prices following the U.S. ban on Russian oil purchases. We believe inflation could ultimately moderate to below 4% by year end given the Fed’s more aggressive tightening schedule and the potential improvement of global supply chain constraints resulting from an easing of worker shortages driven by recent trends in the labor market and the transition of COVID-19 from pandemic to endemic status.
In summary, we now believe the Fed will likely raise rates by 0.25% at five of its remaining six meetings this year, with a 0.50% increase at one of them, concluding CY 2022 with a federal funds target range of 2.00%–2.25%. We also now believe a realistic year-end range on the 10-year Treasury yield to be 2.50%–2.75%.
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