Chief Investment Officer | Johnson Financial Group
As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy to provide consistent, actionable investment solutions for our clients.
4 minute read time
After this week’s Federal Open Market Committee meeting (the Federal Reserve’s decision-making body), the Chairman announced an increase in the Fed Funds rate to 0.25%. A quarter of one percentage point. Doesn’t sound like much, but if you follow market pundits, you know that they have obsessed about this day for the last year. So now that the day is finally here, what does it mean?
After the FOMC meets, its public statement is picked apart by pundits and investors to see what has changed from the last statement and how the new views will impact future decisions.
This week’s statement is no different. And there were several changes worth noting. Regarding inflation, the Fed noted it “remains elevated” and reflects “supply and demand imbalances related to the pandemic, higher energy prices and broader price pressures.” The Fed is not known for clarity! In other words, the Fed recognizes that inflation will be more persistent than originally thought as supply/demand imbalances remain (e.g., a lack of new cars elevates the cost of used ones). It also acknowledges that higher oil prices resulting from the Russian invasion of Ukraine and slower investment in discovery, over the last several years, will keep energy prices higher for some time.
Going on, the Fed acknowledges the impact the war may have on the economy and inflation, stating that “the invasion and related events are likely to create additional upward pressures.” This statement provides some insight into the Fed’s thinking and tells investors that the war has some bearing on its future decisions about raising interest rates.
While the markets have rallied in the last two days based on statements indicating that Ukraine and Russia are trying to negotiate a settlement, the global impact of the war will not be over quickly, and the Fed is acknowledging that.
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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.
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.
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.
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