The Federal Reserve jumped into its post-pandemic tightening cycle by setting forth an aggressive rate-hiking path in an effort to contain inflation while sustaining the economic expansion. Despite the removal of accommodation amidst geopolitical uncertainty, the markets took the Fed’s message largely in stride. Although short term rates rose to reflect the Fed’s steeper expected rate hike path, both inflation expectations and long-term Treasury yields fell, while stocks and credit products rallied, suggesting the markets see the potential for the Fed’s balanced approach to deliver a soft landing.
The Federal Reserve’s announcement at the end of its FOMC meeting on March 16, 2022 surprised on the hawkish side, with the updated projections for the Fed funds rate signaling that it is “all in” on the fight against inflation. The Fed’s statement did not dwell on the many uncertainties regarding the economic outlook, except for an acknowledgement of the uncertainty created by the war in Ukraine. Instead, the Fed’s relatively terse statement focused on recent strengthening economic conditions—including employment—and ongoing elevated inflation. Given the focus on the economy’s current strength, Fed officials aggressively ratcheted up their plans for rate hikes and signaled Quantitative Tightening is likely to begin this spring, perhaps as early as the Fed’s next meeting in May (more details are expected when this meeting’s minutes are released in a few weeks).
The Tightening Trajectory
The Fed’s more hawkish stance now envisages a total of seven rate hikes this year, followed by another four next year, taking the Fed funds rate to 1.9% by the end of 2022 and 2.8% by the end of 2023. The higher path assumes the Fed funds rate will remain at 2.8%—i.e., above the Fed’s 2.4% estimate of the long-run neutral rate—through 2024. Within that time horizon, growth is expected to moderate from 2.8% this year to 2.0% by 2024, while inflation, similarly, remains elevated at 4.3% this year, but decelerates to 2.3% by the end of 2024. During these years of adjustment, the unemployment rate is expected to remain a benign 3.5%-3.6% at the end of each year.
At the press conference, Chair Powell was asked what effects the Fed’s more hawkish plans might have on the labor market—specifically: would the unemployment rate indeed fall a bit further and then remain at a low 3.5% through next year as the Fed’s projections indicate? In his answer, Powell pointed to the current extreme imbalance between labor demand and supply—job openings exceed the number of unemployed by a wide and historic margin. Tightening financial conditions, led by Fed policy, would be expected to lessen excess labor demand and associated wage increases, while not affecting current employment conditions and the unemployment rate.
Consistent with the Fed’s benign outlook for the unemployment rate against a backdrop of significantly tighter monetary policy, Powell noted at the outset of the conference that the probability of a recession appears low, in his view. And in fact, maintaining full employment on a sustained basis requires price stability. Thus, as Powell put it, the Fed is on a course to induce more “normal” financial conditions that could help sustain the economic expansion from here.
A Re-assuring Shock
Although the markets were shocked by the Fed’s accelerated rate hike path, the Treasury and TIPS markets took the news constructively, pricing in a higher probability of an eventual soft landing and quicker return to price stability. Breakevens, or the expected inflation rates priced into the Treasury market, fell (Figure 1), and the nominal Treasury yield curve broke—short rates rose and long rates actually fell (Figure 2).
Figures 1 and 2
Breakevens and Long-Term Treasury Yields Fell Reflecting the Market's Faith that the Fed is “All In” on the Inflation Fight
Bloomberg as of March 16, 2022.
Although initially unnerved by the revised Fed rate-hike path, stocks, credit, and currencies rebounded strongly and rallied as risk appetite improved while the press conference progressed, suggesting the markets were gaining confidence that the Fed would take a balanced approach, forceful enough to control inflation, but not so aggressive as to stifle growth (Figure 3).
Figure 3
Stocks Rose and Credit Spreads Tightened, Reflecting Confidence That the Fed’s Balanced Approach Will Manage to Contain Inflation Without Stifling Growth
Bloomberg as of March 16, 2022.
While this year’s ultimate market outcomes will hinge on a range of related economic and geopolitical factors, the fact is that, following recent corrections, markets have reached a point that prices in, or presumes, a fair amount of rate hikes and economic stress. As a result, it would not be surprising to see—as is typical at this point in the cycle when the yield curve has gotten well ahead of the Fed—rates stabilize and credit spreads narrow as investors begin to inch back into the market in search of yield.