by Brad Houle, CFA
Principal
Fixed Income Research and Portfolio Management
“There isn’t a painless way to get inflation behind us.”
— Federal Reserve Chairman Jerome Powell, September 21, 2022
Investors were expecting Wednesday's Federal Reserve announcement of a .75% increase in short-term interest rates. However, they were unprepared for Fed Chairman Powell's hawkish press conference afterward, resulting in a decline in both the stock and bond markets. A "hawkish" Federal Reserve focuses on increasing interest rates to “tap the economy's brakes” to control inflation, whereas a "dovish" approach means lowering interest rates to stimulate the economy. Wednesday's message was clear: the Fed is taking a strong position against inflation.
Powell's comments indicated a laser-focused stance on controlling inflation while acknowledging that the process will not be pleasant for investors. Also announced, the predicted Federal Reserve’s terminal rate, or the rate at which the Fed stops increasing interest rates to control inflation, was higher than expected. Fed officials now see short-term interest rates at 4.25%-to-4.5% by year-end 2022, implying an additional .75% increase in November and .50% in December.
For the Fed, words are often more important than action, and Chairman Powell has excellently communicated the Fed’s intended direction to set the stage for investors. Once the Fed articulates a path, the market works by building expectations of Fed movements in the markets. Inflation is a lagging indicator, meaning that changes in inflation will lag the actions of the Fed. Generally, there is at least a 12-month lag in seeing the impact of tightening monetary conditions and the actual impact on inflation. Using the chart below, you can see that the inflation measure favored by the Fed, personal consumption expenditures (PCE), has started to decline.
Source: Bureau of Economic Analysis
Good news is challenging to find in this week’s Fed announcement and the capital markets’ reaction. However, our view is that inflation is in the process of peaking, and this trend will manifest in the inflation data in subsequent months. If there is a discernable trend in declining inflation data, risk assets such as stocks should start to look past the aggressive actions of the Fed. In addition, while the economy is slowing, we do not see conditions that would result in a severe recession.
Takeaways for the Week
The Fed announcement was more hawkish than expected, causing the stock and bond markets to decline
Inflation is in the process of peaking and starting to decrease. The question is how fast it will decline and how aggressive the Fed will have to continue to be to get it under control