Plus 0.25%!

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It is also important to note what the Fed has stricken from its statement, as the deletions also reflects their change in thinking. Most importantly, the Fed deleted the words “overall financial conditions are accommodative.” This is Fed speak for we’re going to start hiking interest rates and stay at it for some time. The Fed also deleted a statement regarding the notion that the direction of the economy depends upon the “course of the virus.” It seems the Fed is willing to say that while the pandemic may not be over, it certainly isn’t the focal point of its policy making from this point forward.

The following statement probably best summarizes how the Fed feels about its current policy: “with appropriate firming in the stance of monetary policy, the Committee (FOMC) expects inflation to return to 2% and the labor market to remain strong.”

More Fed speak, wherein the Fed reminds us of its two policy objectives. Fight inflation and maintain a strong labor market. When it says “firming,” the Fed is referring to higher interest rates, and we know now that the first 0.25% hike won’t be the last. So, investors will continue to ask how many hikes, for how long and where will it end.

The Dots

Each time the FOMC releases a statement, it provides some insight into its forward thinking about the direction of interest rates. This is known as the “dot plot,” and you can see why in the graph below. The yellow dots on the chart below represent each FOMC member’s projection for the Fed Funds rate on that date. For example, the high projection for 2024 is 3.50% and the low projection is just over 2% (we’re now at 0.25%-0.50%). The green line represents the median and the white line the Fed Funds futures market. As you can see, the futures market (i.e., bond investors) don’t agree with the Fed and believe that rates will not get as high as FOMC members suggest.

Source: Bloomberg

Why? Because investors know that the Fed usually starts hiking rates too late, which certainly seems to be the case this time, and that means investors see the economy slowing before the Fed finishes its hiking cycle. If the economy is slowing, the Fed needn’t continue raising rates.

But there is a rub this time around. Because of the great growth driven by the pandemic recovery last year, the economy is already slowing. In fact, some expect growth to be less than 2% for this year after reaching more than 6% in 2021. However, inflation remains stubbornly high at more than 7%, and so the Fed must start raising rates.

Pundits are referring to this situation of slowing growth and high inflation as a “stagflation” environment. The definition of stagflation, however, is an environment where (1) inflation is persistently high, (2) unemployment is stubbornly high, and (3) the economy’s demand is stagnant.

Let’s tick through those points. Inflation is high. Unemployment, however, is 3.8%—and there are more than 10 million unfilled jobs! Not a weak market. Demand is waning but still strong. This week retail sales were revised up for January and positive for February. Year-over-year spending was up 17.6%, reflecting the pandemic recovery. Looking forward consumption will likely decline as higher prices and declining sentiment take hold.

So, while not necessarily stagflation, the current environment provides enough uncertainty to remain invested and reduce risk. Portfolios will likely include more focus on companies that produce consistent growth and cash flow as well as better credit quality.

The bottom line is that while +0.25% doesn’t represent a big change, it represents an absolute about-face for the Fed and the future of monetary policy, so it bears watching, to say the least.