Posted by Lawrence Gillum, CFA, Fixed Income Strategist
Thursday, July 28, 2022
The Federal Reserve (Fed) ended its two-day Federal Open Market Committee (FOMC) meeting yesterday and the outcome was broadly in line with market expectations. As expected, the Committee raised short-term interest rates by 75 basis points (0.75%) to take the fed funds rate to 2.5% (upper bound). The 2.5% level is the level, by the Fed’s estimate, to be neutral in the long run; that is the level where monetary policy is neither contractionary nor expansionary. As inflationary pressures continue to run much higher than the Fed’s 2% target, the fed funds rate will need to get above the neutral level to help balance aggregate supply and demand. Finally, the Committee maintained balance sheet normalization with initial reinvestment caps at $47.5 billion until fully reducing Treasury and mortgage securities by $95 billion per month beginning in September.
“Market volatility will likely remain elevated until the Fed starts to slow the pace of rate hikes,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “However, until inflationary pressures start to significantly recede, the Fed has to continue to tighten. If they pivot before inflation starts to definitively fall, we could be in that dreaded stagflationary environment that characterized the ‘70s and ‘80s. Hopefully the Fed has studied up on its history.”
During the press conference, which took place immediately after the conclusion of the FOMC meeting, Chairman Jerome Powell seemingly indicated a willingness to slow the pace of rate hikes. First, Powell acknowledged that the economy is slowing (which is what the Fed wants) and the full effect of the rate hikes has not yet been felt. Moreover, he said the Committee would react to growth, labor market and inflation data, versus only focusing on inflation data. Finally, Powell commented that 75 basis point hikes are “unusually large”. As such, and as shown in the LPL Chart of the Day, market expectations for future rate hikes have come down. Now, the market expects a peak fed funds rate around 3.3%, down from a nearly 4% rate that was priced in last month.
We continue to think the Fed will likely increase rates this year up to approximately 3.5% if the labor market remains stable but could begin cutting again in late 2023 if the economy shows significant weakness. The next FOMC meeting is not until September and the Fed will have two more inflation prints to mull over when deciding the next rate hike (which we think may be 50 basis points but that will be very dependent on the economic data over the next two months). However, this morning’s negative -0.9% annualized 2Q GDP print certainly puts the Fed in a difficult position and may make a softish landing that much more difficult to achieve.
IMPORTANT DISCLOSURES
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.
Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. For more information on the risks associated with the strategies and product types discussed please visit https://lplresearch.com/Risks
References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.
Unless otherwise stated LPL Financial and the third party persons and firms mentioned are not affiliates of each other and make no representation with respect to each other. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services.
All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.
Securities and advisory services offered through LPL Financial, a registered investment advisor and broker-dealer. Member FINRA/SIPC.