• Fed Funds overnight range increases 0.75% to 2.25% - 2.5%
• Projections show Fed Funds at 3.4% by December 2022 — another 1% still to go
• Forecast target peak rate of 3.4% in February 2023
• Balance sheet reduction steps up in September as planned

A change

Following market expectations, the FOMC raised the overnight Fed Funds target by three-quarters of a point today. The unanimous vote supported the Committee’s view that they are “strongly committed to returning inflation to its 2 percent objective.” The increase in the short-term target from March’s 0.25% to today’s 2.5% is the fastest increase in rates since 1994.

The press release opened with the sentence: “recent indicators of spending and production have softened.” This is a change in Fed-speak; over the last month, a number of members talked about the economy’s strength and that the possibility of recession was “low” or “zero.”

The statement did, however, maintain the recent language regarding the Committee’s decisions being “data dependent.” In other words, if the economy continues to slow down, the Fed may adjust how fast or how far it goes in raising interest rates. The Committee reiterated that it is determined to bring inflation down, and that it “is highly attentive to inflation risks.”

The target

Chairman Powell reiterated in his press conference that lowering inflation is still the goal, but rate increases could be adjusted if inflation slows. He acknowledged that to achieve lower inflation, a drop in employment and a weaker economy may be side effects. The Committee believes a period of below-trend growth is necessary to create some slack in the economy. This is Fed-speak for, “if a recession happens, that’s ok — if it brings inflation down.” 

Over the last six months, headline consumer price inflation has averaged 8.3%, with June’s reading hitting a forty-year high of 9.1%. Is this the peak? Thanks to slightly lower gasoline prices, the headline may be peaking. The core CPI, which excludes food and gas costs, is likely to trend higher for several months because housing price changes take up to six months to impact CPI.

Commodity prices peaked for this cycle earlier in the year. Although off their peak, most remain well above their pre-pandemic levels. Lower raw materials prices take about a year to funnel through to consumer prices. Markets sense that inflation is going to stick around and believe the Fed will continue to increase rates. The Fed’s next meeting announcement will be on September 21, 2022. Futures contracts project at least a 55% chance of another 0.75% increase. Interestingly, there are no real odds for a smaller increase.

Reaction

The bond market’s reaction started back in June, when economic data began trending lower in earnest. Peaking June 14 at 3.49%, the 10-year Treasury Note is three-quarters of a percent lower today at 2.74%. Lower long-term interest rates imply that traders see growth slowing further in the coming months. Tomorrow’s release of the second quarter estimate of the U.S. economy’s gross domestic product will show little, if any, growth. Lower interest rates are consistent with the Committee’s view that job layoffs and slower growth are the price to pay for breaking inflation.  

Despite the media drumbeat for recession, the economy has yet to see a broad downturn in employment and activity. A slowdown is not a recession. Stocks are responding well to the Fed’s statement and Chairman Powell’s press conference. We believe traders are focusing on the new language that the Fed finally recognizes that the economy is slowing. In turn, slowing conditions may persuade the Fed to slow or even stop rate increases. Remember, stocks look ahead six to twelve months. Lower interest rates can improve financial conditions and valuations for certain stocks. Stocks have risen steadily today, anticipating that the Fed may recognize when they have raised rates far enough.  

Summary

We are encouraged that the Fed “gets it,” that the global economy, particularly Europe, is slowing. Falling demand may lower price pressures in the coming months — enough to cause the Fed to pause its rate increases later in the fall. We believe that scenario has a high probability. If that is the case, then a mid-cycle slowdown will catch the recession crowd by pleasant surprise.  

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Steve Orr is the Executive Vice President and Chief Investment Officer for Texas Capital Bank Private Wealth Advisors. Steve has earned the right to use the Chartered Financial Analyst and Chartered Market Technician designations. He holds a Bachelor of Arts in Economics from The University of Texas at Austin, a Master of Business Administration in Finance from Texas State University, and a Juris Doctor in Securities from St. Mary’s University School of Law. Follow him on Twitter here. 

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