Years of experimental central bank policy leave the Fed facing difficult choice

“Markets are in a tizz about the prospect of a faster-than-expected tightening of monetary policy from the US Federal Reserve and there still seems to be plenty of life in the old saying about ‘three steps and a stumble’ when it comes to the central bank raising interest rates,” says AJ Bell Investment Director Russ Mould. “On this occasion the Fed hasn’t even got to the third increase before stock markets - and this time bond markets too - have wobbled, as investors price in a sequence of hefty rate rises through to the end of the year.

Source: Refinitiv data

“According to the CME Fedwatch survey, markets are putting a 98% chance on a three-quarter point rate rise to 1.75% at the FOMC meeting, with a 2% chance of a full one-point increase to 2.00%. The central bank is also expected to stick to its plan of reducing Quantitative Easing by $47.5 billion a month in June, July and August before accelerating the scheme to reduce its $9 trillion balance sheet by $95 billion a month thereafter.

“By the end of the year, markets are pricing in a Fed Funds rate upper band of at least 3.75%.

Source: US Federal Reserve, Refinitiv data

“That looks very dramatic and by the standards of the post-Financial Crisis era, it is. The Fed Funds rate last stood above 3.5% in late 2008, when the US central bank was frantically slashing borrowing costs in an unsuccessful effort to stave off a deep recession.

“But there are two problems here and they leave the Fed in a bind.

“First, the last time US inflation was at 8.6% in late 1981, the Fed Funds rate stood at 12%. That implies the US central bank is so far behind the inflationary curve this time around that it can barely see it – hence markets’ expectations of an accelerating upward rate cycle this time.

“Second, there a clear trend of each Fed rate cycle peaking at a lower level. This is because progressively lower rates (and then QE) have encouraged more borrowing by Government, corporations and consumers alike. As a result, the US economy is much more sensitive to even minor changes in interest rates. It means the chances of headline borrowing costs returning to early-1980s levels in the fight against inflation look to be nil – the US economy just wouldn’t stand it.

Source: FRED – St. Louis Federal Reserve database, Refinitiv data

“Thirteen years of experimental central bank policy leave the Fed facing a choice of jacking up rates and tipping the economy into a slowdown, or letting inflation run away and do the same damage in a different way. Heads it loses and tails it loses, unless it catches a lucky break on oil and commodity prices.

“In these circumstances it is no wonder markets are jittery.

“The last time the Fed really got tough with interest rates was under Alan Greenspan, who started raising rates entirely unexpectedly in 1994 – no forward guidance, no mollycoddling markets, nothing.

“There was a rout in the US bond market (and the turmoil claimed the scalp of the British investment bank SG Warburg along the way). The S&P 500 equity index initially stumbled, but then rallied as the US economy remained strong. But there was damage elsewhere as a rising dollar and higher US bond yields took their toll on emerging markets that had borrowed heavily in the US currency. The Mexican Tequila Sunset crisis of late 1994 meant that the Fed rate hike cycle resulted in plenty of collateral damage.

Source: US Federal Reserve, Refinitiv data

“Fed rate hike cycles tend to result in something breaking - either its own economy or stock market, or those of other countries. This time the Fed’s credibility could be on the line, too. Markets have been willing to bet on central bank omnipotence since the Fed’s Paul Volcker crushed inflation in the early 1980s and Greenspan followed him, orchestrating market-rescuing operations and rate cuts in 1998 and then 2000-02.

“But if this rate cycle follows the long-term trend to a lower peak than the last one, as lofty debts take their toll, then inflation could remain sticky for some time and central banks may fail in their 2% inflation mandate.

“What that would do for public and political confidence in them remains to be seen. It could knock faith in low-rate and QE policies and the rampant money creation that has accompanied them.

“Investors and savers could then be forgiven for looking for stores of value in the face of that inflation. If history is any guide that could mean, real, ‘hard’ assets such as commodities and property, rather than ‘paper’ ones like cash, equities and bonds.

“The outperformance of commodities relative to equities over the past year is marked and can be attributed to the invasion of Ukraine as much as it can monetary policy. But if the wisdom and direction of monetary policy come under greater scrutiny, hard assets’ comeback could last for longer than many investors currently expect.”