The Fed Talks Tough And Hikes Big. So Why’s The Market Shrugging It Off?

The Fed Talks Tough And Hikes Big. So Why’s The Market Shrugging It Off?
Stéphane Renevier, CFA

about 1 year ago3 mins

What just happened?

The Federal Reserve (the Fed) hiked interest rates by 0.5 percentage points on Wednesday, bringing its key rate to the 4.25%-4.5% range. The move was mostly expected – though some investors had begun betting on a smaller hike after the latest inflation figures proved milder than expected.

What was surprising was how high the median “dot plot” for the end of 2023 had moved. The dots, which represent the end-of-2023 interest rate projections for the rate-setting members of the central bank, rose to 5.1%, up from 4.6% in September.

The dot plot also shows the Fed expects rates to be 4.1% at the end of 2024, which was also higher than the market is expecting (white line in the chart).

The Fed also released its economic projections: it expects the real economy to grow by a mere 0.5% in 2023, and by just 1.6% in 2024. It sees the unemployment rate rising to 4.6% by the end of 2023 too, up from the current 3.7%.

What does it mean?

Three words: more pain ahead. The Fed keeps hammering the same message: rates are going higher (at least another 0.75 percentage points higher, to be precise), and, more importantly, they’re going to stay higher for longer, until inflation falls decisively toward the central bank’s 2% long-term target. And yes, the Fed’s aware this will bring economic pain. In fact, the Fed is essentially saying that the only way to get inflation back down to acceptable levels is to cause more economic pain.

That should be a really tough pill to swallow for risk assets. But the muted market reaction at the time of writing suggests that investors think the Fed is bluffing. They see the Fed using harsh projections and a rough outlook as a bludgeon against another potential rally in stocks and bonds. That kind of rally, after all, would be akin to an easing of financial conditions, just the opposite of what the Fed is trying to achieve. Investors seem to be betting that inflation will fall quickly enough and decisively enough to allow the Fed to soften its stance. Put more simply, they just don’t see this playing out the way the Fed says it will.

Why should you care?

As you’ve no doubt realized this year, rising interest rates are negative, not just for the economy, but also for asset prices. Now we’re getting closer to the peak for interest rates, and that puts us in an interesting spot. On one hand, the most aggressive of all those hikes are likely past us, and we’re closer now to a pause in interest rates (and eventually, a cut). That should be good news for asset prices. On the other hand, the current interest rates, which are a lot higher than they were before, are likely to significantly slow the economy, and possibly push it into a recession. That’s bad news for risky assets like stocks, as their earnings are likely to take a hit.

Investors seem to be betting that the effect of the former trumps the latter. And there’s a chance they’re right: falling inflation could allow the Fed to deviate from its aggressive path before it's too late. And if the US labor market remains strong and growth remains resilient, the US economy could even experience a soft landing – that dream scenario where inflation eases back toward its target without a harsh economic plunge. But the higher interest rates rise, and the longer they stay elevated, the harder the fall – for the economy and for companies’ earnings. And because of the long and convoluted lag that exists between rate hikes and the economy, achieving just the “right amount” of slowdown is easier said than done. We might avoid the worst-case scenario, but I wouldn’t bet on achieving the best.

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