Investment strategy
July 27, 2022

Full steam ahead: Fed raises US interest rates again by 75bps

July 27, 2022
Bruce Harris
Head of Global Fixed Income Strategy
SUMMARY

At its July meeting, the US Federal Reserve’s Federal Open Market Committee (FOMC) again raised the interest rate by 75bps (2.25%-2.50%). This marks the second 75bps hike in as many months. Investors may potentially view the development as an opportunity to obtain longer term core income for their portfolio via quality fixed income exposure.


  • Other policy rates such as the interest rate on excess reserves (IOER – rate paid to banks for reserves) and the overnight reverse repo rate (RRP – rate paid to funds for overnight deposits) were also raised to 2.40% and 2.30% respectively.
  • The Federal Reserve’s quantitative tighteningprogram continues at a reduced pace.  The Fed’s holdings of securities on its balance sheet has declined slightly since the peak of $8.5 trillion in May to about $8.45 trillion, a drop of about $50bn in two months.  As with last month’s meeting, the Fed provided few details on increasing the pace of balance sheet reduction other than to reiterate their target of $95 billion reduction per month starting in September.
  • Overall, the FOMC statement was as expected by the market, and while the Fed indicated the need for additional rate hikes, the statement as neutral, given that there was little forward guidance other than a repeat of last month’s comment that the Committee…anticipates that ongoing increases in the target range will be appropriate. Fed Chairman Jerome Powell’s press conference initially was more hawkish in tone, with repeated emphasis on high inflation and a tight labor market, though Powell did start to indicate a possible end to rate hikes in the future with the result being a sharp equity market rally.
  • The FOMC statement primarily focused on inflation, though there was a reference to slowing economic growth: recent indicators of spending and production have softened, even as job gains have been robust. In reference to inflation, the Fed stated again that it was highly attentive to inflation risks and strongly committed to returning inflation to its 2 percent objective. This was a repeat of language from last month’s statement.
  • Chairman Powell noted in his press conference after that: another unusually large increase could be appropriate at our next meeting. This implies that Powell did not rule out a 75bps move in September.  However, he then went on to say that it will likely be appropriate to slow increases at some point, and that he would like to see the terminal rate as moderately restrictive, which at least initially both the fixed income and bond market found as dovish.

 

Our takeaways

  • Just last year, Powell noted that lags in the timing of monetary policy’s peak impact means that monetary easing or tightening can come at a time after when the need has passed. While we don’t believe policy easing should have continued (QE just ended in March), a pro-cyclical US monetary policy is now a risk looking forward given the large build-up of monetary and fiscal restraint.
  • By raising rates this quickly, while the Fed may achieve its goal of reducing inflation somewhat by pushing down demand, it may also perversely prolong a higher price environment for longer due to both adding to company costs and leading to firms’ underinvestment.
  • While the Fed may be trying to lower demand and therefore prices even if this risks a recession, this drop in demand may simply result in a corresponding drop in supply.
  • This combination of more ingrained long-lasting cost pressures and declining production is the essence of why stagflation is so pernicious and destructive. The Fed clearly needed to raise rates and tighten monetary policy, but it would be more prudent in our view to do so more gradually. Given the Fed’s history of easing – and now using QE – in recessions, the Fed should consider a policy tightening trajectory that it can sustain.
  • We think the Fed will ultimately heed the bond market’s signal and the latest comments by Chairman Powell may be the first step towards a pause once we reach a 3-3.5% fed funds rate. For now, the Fed has the space to bring Fed Funds up closer to market expectations without committing one way or the other. Accordingly, the Fed is using that space in this meeting and likely again in the next with another large rate hike in September.
  • But we think by the fall a clearer picture will emerge on both inflation and the economy and enable a better view on how much further the Fed can hike, and Powell’s comments about a slowing economy today are indicating that the Fed is now more balancing risks as opposed to unilaterally committed to fighting inflation.
While inflation is expected to remain high in the near term and yields and credit spreads may yet move somewhat higher, in our view investors should consider these higher yields offered by quality credits as an opportunity to obtain longer term core income for their portfolio.

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