“Shock is still fun. I won’t ever shut the door on it.” – Nicolas Kim Coppola, known professionally as Nicolas Cage, American actor and filmmaker
The Fed Gears Up for Shock and Awe
Perhaps Nicolas Cage finds shock fun, but, since the beginning of the year, investors have likely felt otherwise as the markets have been shocked by persistently high inflation and the question of how the Federal Reserve might respond.
In March, the Fed began with a simple 25 bp (bp = basis points, 1 bp = 0.01%) rate hike in the fed funds rate to a range of 0.25%-0.50%. However, unlike the rate-hike cycle of the 2000s and the very gradual increases in the 2010s, inflation is a big problem today. The last Fed move, on May 4, 2022, was the second increase in the funds rate since 2018, when the Fed completed a cycle of increasing interest rates.
The Federal Reserve increases or decreases this so-called “target rate” when it wants to cool or spur economic growth. We are now hearing comments from key Fed officials that “it is of paramount (emphasis added) importance to get inflation down.” Or: Today’s high inflation “is as harmful as not having a job…. If you don’t have the confidence [the Fed will use its inflation-fighting tools], let me give it to you.” So perhaps we should not expect the baby steps we’ve grown accustomed to.
Based on commentary from most Fed officials, shock and awe is the most likely approach.
With the May increase, the largest single rate increase in more than 21 years, the Federal Reserve began to move more forcefully to address inflation that is running at 40-year highs. The fifty-basis-point (0.50%) increase in the federal funds target rate to a range of 0.75% to 1% puts the key short-term monetary policy rate at its highest level in two years, and additional rate increases are expected to come.
Fed Chair Powell noted that additional 50 basis point moves are “on the table” for the next couple of meetings, June and July, but the rate-setting committee was not actively considering larger increases of 75 basis points or more. That is to say, we may still see the most aggressive pace of tightening in almost 30 years.
An aggressive tightening cycle can generate volatility in several ways. First, higher interest rates compete more effectively for an investor’s dollar, siphoning cash away from stocks. Second, higher interest rates can slow economic growth, which may put the brakes on profits and profit growth. Third, higher interest rates on new loans and variable rate debt would mean higher borrowing costs for the consumer. The demand for goods and services will then drop, which will cause inflation to fall.
The Fed is also concerned with external events that influence economic growth and inflation, although there’s nothing that the Fed can do to change them. More realistically, investors want signs that inflation is not only peaking but on a downward path. Why? It would reduce the need for steep rate hikes. Powell and the Fed are hoping to slow inflation without tipping the economy into a recession. But they will need skill and, perhaps, some luck.
High inflation, slowing global growth, and the ongoing war in Ukraine have all been news headlines. The pullback in stocks reflects the high level of negative sentiment, and, at least in part, stiff headwinds are already priced in. Are we at or near a bottom? We don’t try to call bottoms or tops, and those articulate analysts on the financial news networks may be smart, but they don’t have a crystal ball.
We do not believe investors should be taking outsized risks. Successful investors are disciplined. They refuse to let excess optimism or pessimism guide their decisions. It is time to employ a disciplined approach and maintain recommended asset allocations. Just as these ‘guardrails’ can keep you from lurching into riskier assets when stocks are quickly rising (and we feel invincible), the parameters are also in place to prevent emotion-based decisions that can sidetrack you from your long-term goals.
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