Rock, meet hard place: FOMC signals 'hawkish' tightening path

• This is the first time the rate has been raised since December 2018. Other policy rates such as the IOER (paid to banks for reserves) and the RRP rate (paid to funds for overnight deposits) were also raised to 0.40% and 0.30% respectively.

• The Federal Reserve’s quantitative easing program finally ended this month. The Fed balance sheet now sits just shy of $9 trillion, an increase of almost $5 trillion since the start of 2020. The Fed is likely to begin reducing the size of its balance sheet (quantitative tightening, or QT) sometime later this year. The Fed did not provide any new information on how or when it plans to operationalize QT, other than to say that it expects to begin reducing its holdings of Treasury securities and agency mortgage-backed securities at a coming meeting.

• The Fed also acknowledged the Ukraine conflict, stating: The invasion of Ukraine by Russia is causing tremendous human and economic hardship. The implications for the US economy are highly uncertain, but in the near term the invasion and related events are likely to create additional upward pressure on inflation and weigh on economic activity.

• Fed Chairman Jerome Powell noted in his press conference after that: inflation is likely to take longer to return than previously expected, as well as probability of a recession is not particularly elevated. All signs are that this is a strong economy that can not only withstand but flourish in the face of less accommodative policy.

• Powell also stated that no matter what happens the Fed is determined to prevent high inflation from becoming entrenched in the economy, while also noting that the job market has tightened to an unhealthy level and that Fed action will cause financial conditions to tighten: Policy works through financial conditions. That’s how it reaches the real economy. The implication of these statements is that the Fed is determined to reduce inflation, and it is ok with the job market cooling off and the asset markets to become less frothy.

• By openly discussing QT in parallel with rate hikes, the Fed came across as very hawkish in January, even though it was still engaged in monetary accommodation (buying bonds) at this meeting. This dissonant messaging between words and action is probably best interpreted as the Fed was standing ready to bring inflation down forcefully, while hoping it would not have to do so and thereby giving itself policy space and optionality if data didn’t go in its direction.

No easy path forward due to geopolitical conundrum

• However, with the conflict in Ukraine spiking commodity prices and continued supply chain issues (and perhaps a continuation of these due to new Covid-19 lockdowns in China), the US is likely to experience persistently higher inflation for some time to come. This presents the Fed with no easy path forward given their dual mandate of maximum employment and low inflation.

• The US economy is at or near maximum employment, yet inflation is the highest it has been in 40 years. If the Fed follows through and aggressively targets inflation, they risk reducing employment over the medium-term due to a recession. If the Fed adopts a more passive approach to combating inflation, they risk losing credibility in protecting the purchasing power value of the US Dollar, and perhaps even demand destruction due to stubbornly high prices (often referred to as stagflation).

• We had expected that credit would widen into the Fed’s tightening cycle and adjusted our model portfolio accordingly by remaining underweight in high yield bonds and reducing exposure to bank loans, as well as seeking credit hedges.

• But now that credit has broadly moved wider, investors should consider these higher yields as possible new entry points given that the Fed’s tightening path is coming more into focus, which may help reduce volatility.

• While inflation is expected to remain high in the near term, and longer-dated bonds may yet need to move somewhat higher in yield to build in term premium, yields are starting to look attractive in several indexes, especially if the Fed’s tightening policies help engineer much lower inflation without overly harming growth.