The Federal Reserve forecast an aggressive campaign of interest rate hikes to fight inflation, but that raises the question of whether the central bank can actually succeed without doing serious harm to the economy.
The Fed raised interest rates by a quarter-point Wednesday, the first hike since 2018. At the same time, its forecast showed Fed officials expect six more rate hikes this year and three next year.
Stocks rallied and ended the day sharply higher, after initially selling off on the central bank’s forecast. The Dow was up 518 points, or 1.5%, while the Nasdaq jumped 3.8% to 13,436. In the bond market, yields jumped but were off their highs later in the day. The 10-year yield, which influences mortgages and other loans, was at 2.19%, down form 2.24% at its intraday high. Yields move opposite price.
“In my career, today’s Federal Reserve meeting is the most vetted-before-the-fact meeting I’ve ever witnessed,” said James Paulsen, chief investment strategist at Leuthold Group. “The stock market started to respond to this last August.”
Pauslen said the stock market had a “sell the news” type of reaction and it could be set up for a rally. He noted that seven rate hikes were priced into the bond market even before the meeting, but many economists had expected the Fed would only forecast five or six.
“A lot of this is priced in, but the bigger issue for the market is whether we are going to see a recession,” said Paulsen.
While economists are not forecasting recession, they do see slower growth, and the picture has become more clouded since Russia invaded Ukraine. That war sparked its own inflation wave since Russia is a major commodities producer, and the conflict and sanctions raise doubts about supplies of oil, wheat and other major exports.
“I think the Fed is too aggressive here,” said Simona Mocuta, chief economist at State Street Global Advisors.
Economists have been revising down growth forecasts due to the Russian invasion of Ukraine.
“How the economy evolves is highly uncertain. They may not come to pass, but certainly the Fed delivered a very strong message. … I’m still skeptical we’ll get all these rate hikes,” said Mocuta.
Economists had expected the Fed to sound hawkish, or aggressive, when it delivered the first rate hike. Many had viewed the Fed as behind the curve because it initially viewed inflation as transitory, and they felt it held onto that view for too long.
‘An inflationary shock’
Inflation has continued to rise more than expected. The consumer price index jumped to 7.9% in February and is expected to be even higher in March. In the second half of the year, inflation should slow down in part because of base effects in comparisons.
“The policy trade-off wasn’t great before the Ukraine, but Ukraine makes it worse. It’s an inflationary shock but driven by factors the Fed can’t control,” Mocuta said.
The Fed is likely to carry out the first few rate hikes, Mocuta said, but it should revisit the path of hikes and the economy in the third quarter.
If the situation in the Russia-Ukraine conflict were to improve, some pressures on inflation and supply chains would ease. Some supply chain pressures from the pandemic could also fade as the year wears on.
“The way I’d say it is they’re signaling what they need to signal, but whether they actually act on it is an open question,” said Drew Matus, chief market strategist at MetLife Investment Management. “This is not a demand side story. … I don’t understand what the Fed will achieve with that by way of inflation. There are supply chain issues and energy issues that have nothing to do with the Fed.”
The Fed also expects that core inflation will be 4.1% this year, falling to 2.6% next year after the rate hikes. The forecast also had gross domestic product growing at 4% this year and falling to 2.2% in 2023. Fed officials saw the unemployment rate falling to 3.5% and staying there.
“A lot of their forecasts don’t make sense. … You have inflation coming down. You have growth coming down, but you have the unemployment rate staying steady,” Matus said. “When you look at the unemployment rate staying steady. There are some gaps in the logic.”
Matus said one of the gaps is that the Fed would not be able to achieve that economic forecast if it really were to raise rates at the projected pace.
But others do expect the Fed to proceed, and seven rate hikes for this year has been in some Wall Street forecasts.
“They’re serious. They’re really far behind the curve on inflation. Those who don’t think they will be able to execute seven hikes, they’re in for a rude shock,” said Mark Cabana, head of U.S. short rate strategy at Bank of America.
Grant Thornton’s chief economist, Diane Swonk, said markets should take the Fed at its word.
“We cannot risk stagflation. They admitted they now expect inflation to be hotter for longer, and it wasn’t just a Ukraine issue,” she said. “Seeing the market reaction — clearly they don’t believe it. This is a monumental shift in the Fed outlook in terms of rate hikes. They do that for a reason, and it wasn’t just one person at the Fed, an outlier. It was a systemic move across the Fed, even the most dovish Fed officials.”
Swonk said the Fed’s forecast on unemployment may not add up, but the central bank seriously wants to bring down inflation.
If Fed officials move as forecast, there are risks. “When I model seven rate hikes, which is what my forecast is, I see the economy stalling out to 1% average growth in the second half,” she said. “It’s a semihard landing.”