Fed Hikes: Too Much, Too Late?
How much will the economy be rocked by the central bank’s delayed but aggressive response to high inflation?Download PDF
- Lowering inflation continues to be the Federal Reserve’s top priority.
- Rising interest rates will likely dampen investments, hiring and consumption.
- Despite a challenging environment, U.S. companies and consumer spending have so far been resilient.
- The question remains: Will the Fed’s aggressiveness in fighting inflation be too much, too late?
Equity markets continued to fall over the third quarter of 2022 with the S&P 500 Index down 4.88% for the period. Growth stocks fared better than value stocks, while small-caps outperformed large-caps over the third quarter. Domestic equities outperformed foreign stocks, particularly emerging markets. China continued to drag performance, as its zero-COVID lockdowns have hindered economic activity.
Within fixed income, short-duration bonds held up much better than their longer-duration counterparts, as yields spiked over the third quarter. Bank loans were among the best performing asset class, due to their floating-rate adjustment feature.
Taming inflation continues to remain the Federal Reserve’s priority as the central bank has been aggressively raising rates after failing to address inflationary pressures earlier. Although we may have reached peak inflation, slowing it down has been a difficult task for the Fed and other central banks. High inflation has been a global phenomenon that’s weighing on consumer sentiment and growth.
Most global central banks have joined the Fed in a fight against inflation, which has had rippling effects through financial markets and the global economy. The recent era of cheap liquidity, which lasted though the worst of the pandemic, looks to be coming to an end. Now, higher borrowing costs will likely dampen investments, hiring and consumption.
The housing market has been particularly vulnerable to the historic rate hikes, although the limited supply of homes may prevent housing prices from coming down too much. Higher interest rates have led to higher mortgage rates, which have hammered home sales. Although the housing market may seem to be in a recession, the overall U.S. economy should be able to avoid a sharp slowdown because of relatively healthy corporate balance sheets. One caveat could be if the Fed hikes interest rates even more aggressively than expected. This could happen if inflation doesn’t come down quickly enough or there is a shock stemming from more geopolitical upheaval.
The war in Ukraine has had a significant impact on inflation, particularly food and energy. Europe is particularly vulnerable to a prolonged war in Ukraine as it had depended on Russian gas. Russia’s latest escalation in the war further complicates the market outlook. Russian President Vladimir Putin has ordered the mobilization of approximately 300,000 more troops and warned of nuclear force to any threat to Russia’s territory.
Despite the global challenges, U.S. consumer spending had been resilient earlier this year, supported by savings. However, those savings from government aid have dwindled as consumers racked up credit-card debt. Credit-card debt in the U.S. has surged over the past year as high inflation dug into savings.
Consumer Credit-Card Debt Has Been on the Rise
Furthermore, interest rates on credit cards have risen as the Fed has tightened monetary policy. This environment has been particularly challenging for those who live paycheck to paycheck and spend most of their earnings on necessities such as housing, food, and gas.
So far, companies have maintained solid profit margins despite paying more for labor and input costs. This is because corporations have benefitted from robust revenue growth due to unusually high pricing power. This situation may change as consumers temper their spending. As a result, companies will likely pare back hiring and capital spending. Employment conditions have been leveling off as hours worked for manufacturing jobs have started to fall. The Fed anticipates unemployment rate will rise to roughly 4.4% next year. Furthermore, higher borrowing costs will likely discourage investments into new equipment and factories.
The market expects Fed Chair Jerome Powell and other voting members to opt for another 75-basis-point hike in November, followed by another 50-basis-point hike by year-end.
Furthermore, the Fed anticipates that it will continue raising rates into 2023. We believe the likelihood of a soft landing for the economy will diminish with each additional rate hike.
To date, the Fed has opted for forceful and rapid steps to moderate demand to align with supply. A year ago, the median expectation for the fed funds rate was below 1% by the end of 2022. Now, the fed funds rate is expected to surpass 4% by the year-end. The Fed made the mistake of reacting to a booming economy too late. Hopefully, they don’t make another one on the other end by tightening too much, too late.
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