The Fed raises rates by 0.75%: Its inflation battle continues

The Fed raises rates by 0.75% and improves its inflation-fighting credibility

As expected, the Federal Reserve today raised rates by 0.75%, its largest increase in 28 years, bringing the federal funds rate to around 1.50%. Of note, Fed Chair Jerome Powell highlighted in his comments that the FOMC's primary focus currently is on bringing down inflation in a "clear and convincing" manner over the next few months.

The markets welcomed this rate hike as a signal of credibility in the Fed's inflation-fighting mandate and a step in the right direction toward bringing interest rates back to more neutral territory. The S&P 500 headed higher by over 1.0% on the back of this move, while the tech-heavy Nasdaq was higher by over 2.0%. Chair Powell did note that while these outsized Fed rate hikes should not be common, he would expect next month's meeting to also bring a 0.50% or 0.75% rate hike, depending on incoming data.

Overall, the FOMC projects the fed funds rate to head toward 3.4% in 2022, which would bring rates more in line with current market expectations and push the fed funds rate to restrictive territory. While this would tighten economic conditions and increase borrowing costs for consumers and corporations, we should also see an impact on core inflation, which we would expect to moderate by year-end.

The Fed's updated projections do not indicate a pending recession, but a slowdown is likely

The Fed also released today a new set of economic projections, which, as expected, lowered growth forecasts and raised inflation forecasts for 2022, although inflation for 2023 is still expected to be lower.

A couple of key takeaways from the Fed's June projections include

• Economic growth will slow to sub-2.0%, but a recession is not in the forecast: The Fed expects the labor market to cool, with the unemployment rate climbing to 3.9% next year, and GDP growth slowing to around 1.7%. While the forecast calls for slowing economic growth, these are not consistent with recessionary conditions; and
• Inflation will peak this year before moderating over the next two years: The Fed increased its inflation forecast for this year, bringing headline PCE inflation to 5.2%. However, it expects inflation to moderate to 2.6% next year and head to 2.2% in 2024. A downward trend in inflation would allow the Fed to raise rates at a more gradual pace.

Figure 1. The Fed's updated June projections

The new Fed projections indicate that the economy will slow, and unemployment will climb gradually, but no recession on the horizon.

Notably, the projections also indicate that inflation will be elevated this year, but come down to 2.6% next year.

A sustainable market rally will depend on the path of inflation

Overall, we believe that with the S&P 500 down close to 20%, markets are already discounting a fair amount of pessimism around the economy. We don't, however, see markets mounting a sustainable rally until we see evidence of moderating inflation – perhaps two to three consistently lower readings. In our view, this could happen by year-end, driven in part by a cooling housing market and potentially softer labor market. While headline inflation (driven by food and energy prices) is more volatile – and less impacted by rate hikes – we believe the Fed's aggressive policy decisions will support a gradual move lower in core inflation and bring down consumer demand over time.

If inflation does moderate, this could allow the Fed to move at a more gradual pace of tightening, which will support market sentiment broadly. This process may take time, perhaps through the second half of the year, and we may continue to see market volatility in the interim. We see this potential recovery as more "U-shaped versus the speedier "V-shaped" market rebounds we have seen in recent history. However, with markets having priced in a mild downturn already, we believe the upside versus downside in markets is certainly more compelling today.

Look to remain diversified and defensively positioned for now

For long-term investors, while market sell-offs are never comfortable, they have historically provided opportunities to diversify, rebalance and ultimately add quality investments to portfolios at better prices. Historically, the time to recovery from a bear-market sell-off has been on average 23 months, but for periods of shallower economic downturns – which we believe will be the case for this cycle – this recovery time is shortened to an average of 10 months (see chart below).

And if this is in fact a nonrecessionary market correction, history is also on our side: Since 1970, the return is, on average, 17% in the six months after the market bottoms. Calling market bottoms (or tops) is notoriously difficult, but with equity-market valuations having come down nearly 25% and with a sizable amount of recession fear priced in, we are likely closer to a bottoming process today.

In this backdrop, we would continue to remain more defensively positioned for now until we see a consistent moderation in inflation. Within equities, we would favor quality large-cap positions over small-cap, with a tilt towards value sectors of the market. And within fixed income, we would favor investment-grade bonds, which now offer better income opportunities and align investors with high-quality issuers. While volatility may remain elevated this year, the silver lining for investors could be that a gradual U-shaped recovery may be underway.

Figure 2. Average bear-market downturns and recovery times

Bear Market Performance and Recovery

Mona Mahajan,
Investment Strategist