On May 4, the Federal Open Market Committee (FOMC) raised the Federal Funds rate by 50 basis points (half a percent)—an increment not seen in two decades. Additionally, the Fed announced that it will start shrinking the central bank's balance sheet in June. Through this process, known as quantitative tightening, the Fed will let the bonds that it holds mature and "roll off" its balance sheet, reducing the money supply in the U.S. economy and scaling back the economic stimulus it provided during the COVID-19 pandemic.
Speaking of the decisions, Federal Reserve Chairman Jerome Powell directly addressed the American people, "Inflation is much too high, and we understand the hardship that it is causing. We're moving expeditiously to bring it back down. We have both the tools we need and the resolve that it will take to restore price stability on behalf of American families and businesses."
Looking forward, some projections estimate three more hikes of 0.5% over the course of the next three FOMC meetings before dropping back to 0.25% for the rest of the year and continuing in 2023 towards a terminal rate of 3.25% to 3.5%. Based on Chairman Powell's comments, each hike will likely be less than 0.75%—despite earlier hints by St. Louis Fed President James Bullard.
As the Fed works to quash lingering inflation, how will these changes impact markets and the greater economy? BOK Financial® Chief Investment Officer Brian Henderson breaks down the Fed's moves and what's likely to come.
What makes this series of rate hikes different from what we've seen in the past?
Henderson: In the last 35 years, the Federal Reserve had the luxury of being ahead of the inflation curve, so they were able to increase rates slowly. For instance, in 2015, coming out of the Great Financial Crisis, it took them several years to increase the benchmark interest rate from 0.25% in December 2008 to 2.5% in 2018.
Today, inflation is well beyond the Fed's 2% target; as of March, we were at 8.5%, as measured by the Consumer Price Index. The Fed is well behind, and it feels compelled to frontload rate hikes. Rather than gradually increasing rates like it did from 2015 to 2018, the Fed is doing it all in nine months.
Plus, because the Fed is so far behind the curve, it's increasing rates late in the current economic expansion. The unemployment rate has already hit multi-decade lows. Normalizing rates at this time, versus early in the economy's expansion, raises the odds of a more severe economic slowdown.
If the Fed's projection of hiking rates a total of 11 times to 2.75% is correct, how would that impact markets and the overall economy?
Henderson: We've been at 2.75% before, but part of the heartache for both the economy and the markets is that the Fed is planning to get there in such a short period of time. Meanwhile, each rate hike has an immediate impact. For example, when the Fed increased rates by 0.25% in March, mortgage rates increased by over 2%.
Looking forward, the bond market already has the equivalent of 11 rate increases of 0.25% priced in. However, other aspects of the economy would be impacted more significantly by higher rates. For instance, corporations with floating rate loans would be hit with higher interest rates, which would put more pressure on businesses that are already strained. Mortgage activity would decline across the board.
Can you explain quantitative tightening a bit more and how it fits into the equation?
Henderson: During the COVID-19 pandemic, the Fed supported the economy through a process called "quantitative easing." That means that the central bank purchased debt securities, such as Treasurys and mortgage bonds, to increase the money supply.
Now, the Fed is doing the reverse—what's known as quantitative tightening. The central bank is allowing $30 billion in Treasurys and $17.5 billion in mortgage bonds to mature without replacing them each month in June, July and August, and then $60 billion in Treasurys and $35 billion in mortgage securities to mature and "roll off" every month thereafter.
The market expected the Fed to start doing this in June and, in a short period of time, reach its goal of reducing its holdings by $95 billion per month since this plan was in the March 2022 FOMC meeting minutes. Although the goal of $95 billion per month is the same, the ramp-up is a little bit slower than what was expected. This move isn't aggressive considering that the Fed currently holds $9 trillion.
One survey indicated that 81% of Americans think the economy is headed for a recession in 2022. Can the Fed quell inflation without driving the U.S. economy into a recession?
Henderson: They have a tough job ahead of them because rate hikes are a blunt instrument. However, recessions are pretty rare: It usually takes a big event like the pandemic, sky-high oil prices or war to throw us into one. Plus, as the FOMC noted in their May 4 statement, there are still a number of positives in the economy right now: strong demand from businesses and households, robust job gains, and the unemployment rate has declined substantially.
If the economy shows signs of slowing down a lot faster than what the Fed expects, they'll slow down rate hikes, even if inflation is still high. They're not going to keep increasing rates and running the economy into the ground.