Federal Reserve focuses monetary policy on fighting inflation

Source: U.S. Bank Asset Management Group

Federal Reserve (Fed) policy actions remain a primary market focus. The Fed raised short-term rates three additional times in 2023 following a series of rate hikes that began in March 2022. At its most recent meeting, held May 2-3, the policy-making Federal Open Market Committee (FOMC) lifted its short-term target federal funds rate to a range of 5.00% to 5.25%, its tenth consecutive interest rate hike. Equity and fixed income markets appear to be signaling their anticipation the Fed may be finished with rate hikes for this cycle and may even cut rates before the end of the year. Yet Fed officials appear to be tempering that speculation.

At the May meeting, the Fed signaled that it may be prepared to pause the current rate-hiking cycle. In later May, Fed Chair Jerome Powell, commenting on the state of the economy, said “our policy rate may not need to rise as much as it would have otherwise to achieve our goals.”¹ His comment came around the same time that other Fed officials made statements indicating that more rate hikes might be required in the coming months. “The sum total of all of these comments may be to temper the market’s expectation that the Fed will begin cutting the fed funds rates before the end of the year,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “Nevertheless, markets continue to anticipate Fed rate cuts before the end of 2023.”

The Fed’s latest decision to raise rates came on the heels of news that a few regional banks faced financial failure. Some investors speculated additional problems in the banking sector, which can affect the availability of credit in the broader marketplace, might alter the Fed’s rate-hiking strategy. If those issues result in reduced credit availability for consumers and businesses, that could contribute to an economic slowdown and limit the need for further Fed rate hikes.

The Fed also retains its commitment to reversing a previous policy of quantitative easing (QE) that involved purchases of Treasury and mortgage-backed securities. QE was aimed at providing more liquidity to capital markets. The Fed began trimming its balance sheet of those assets, from its peak near $9 trillion.² This so-called “quantitative tightening”, combined with higher interest rates, is designed to temper inflation by raising borrowing costs, weakening loan demand, and slowing economic growth.

Cost of living changes, a virtual non-issue for decades, became a dominant concern for consumers in early 2021 and remains an issue today. Powell says the Fed continues to “have the resolve it will take to restore price stability on behalf of American families and businesses.” He notes that price stability is a primary Fed responsibility and seems to indicate the Fed recognizes the importance of tamping down the inflation threat. “Without price stability, the economy does not work for anyone,” says Powell.³

Fed’s new interest rate policy

The FOMC started the “tightening” process in March 2022 by raising interest rates 0.25%. At subsequent meetings, the Fed greatly accelerated the pace of rate hikes, and by the end of 2022, the fed funds target rate stood at 4.25% to 4.50%. The 0.25% rate hike in May 2023 followed similar rate increases in February and March. The fed funds target rate, is at its highest level since October 2007.⁴

Source: Federal Reserve Board of Governors.

The Fed’s actions appear to have achieved some success. By the closing months of 2022 and into early 2023, inflation showed signs of easing. Through April 2023, living costs (as measured by the Consumer Price Index) rose 4.9% over the previous 12 months, a decline of 4.2% from the peak inflation level reached in the 12-month period ending in June 2022.⁵ After the May 2023 FOMC meeting, Powell stated, “we remain strongly committed to bringing inflation back down to our 2% goal.”⁶ Powell added the FOMC does not anticipate inflation reaching that level quickly. “It will take some time,” he stated. “It would not be appropriate to cut rates and we won’t cut rates,” for a period of time. Powell made clear that the Fed is “prepared to do more if greater monetary policy is warranted,”⁷ considered a signal that the Fed is not ruling out the possibility of further rate hikes. That point appeared to be reinforced by several Fed regional bank presidents, who suggested in mid-May that more rate hikes could be considered in the coming months.

Role of the Fed

The Federal Reserve acts as the U.S. central bank. Its functions include maintaining an effective payment system and overseeing bank operations. Investors, however, primarily focus on the Fed’s monetary policies.

In setting monetary policy, the Fed attempts to fulfill three mandates:

• Price stability. The Fed seeks to maintain a stable inflation rate. Its current target is inflation averaging 2% per year over the long term.
• Maximum sustainable employment. Officially referred to as “maximum employment,” it technically refers to a labor market where the unemployment rate is at a low level. The Fed does not use a specific measure (i.e., unemployment rate, labor force participation rate) to as its goal. Instead, it utilizes a more subjective assessment of the employment environment.
• Maintain moderate long-term interest rates. The level of interest rates impacts many aspects of economic activity, from consumer mortgages to business financing. Therefore, the Fed seeks to keep rates at modest levels.

The Fed also influences short-term interest rates, specifically, the target fed funds rate, which is the interest rate applied to overnight loans from one financial institution to another. While Chairman Powell receives much of the attention, the FOMC establishes Fed monetary policy. It’s the committee that sets the fed funds rate target and has other authority, including buying and selling of securities.

Fed funds rate nears a high

Following its May 2023 meetings, the Fed indicated a likely pause in the current rate-hiking cycle. Haworth notes that the Fed remains focused on driving inflation lower. “The Fed wants inflation to be below the fed funds rates, and currently, those numbers are comparable. If inflation rates don’t change much from here, the fed funds rate could go higher, but at this point, rate cuts appear unlikely,” says Haworth.

The intended impact of higher interest rates is to slow economic activity, a strategy designed to cool inflation. If successful, it will likely result in weakening the job market as businesses slow hiring and investments in the wake of higher borrowing costs. However, unemployment hovers near historic lows and job openings greatly outnumber available workers. To attract and retain employees, employers boosted wages. Recent reports show that compensation costs for workers rose 5.1% for the 12 months ending in March 2023,⁸ a slight increase from what had been a downward trend in wage growth.

Haworth believes the Fed sees wage growth as an important measuring stick to determine its inflation-fighting progress. “If wage growth slows, it signals to the Fed that the labor market may finally be showing signs of weakness.” While ongoing labor market strength could create pressure to push wages higher, Haworth notes that “by some measures, it appears wage growth has fallen from its peak levels.”

In comments after the May 2023 FOMC meeting, Fed Chair Powell stated that “reducing inflation is likely to require a period of below-trend (economic) growth and some softening of labor market conditions. Restoring price stability is essential to set the stage for achieving maximum employment and stable prices over the long run.”⁶

An end to the era of “quantitative easing”

The QE strategy the Fed implemented at the start of the COVID-19 pandemic has been curtailed. When QE was in place, the Fed purchased longer-term securities on the open market, including U.S. Treasuries and mortgage-backed bonds. “Under this program, the Fed became one of the biggest buyers of Treasury securities in the market,” says Tom Hainlin, national investment strategist at U.S. Bank. “They impacted the interest rate environment just by their large presence.” Hainlin notes that with the Fed bumping up demand for bonds, long-term interest rates remained low (high demand for bonds typically helps keep interest rates lower).

Since September 2022, the Fed is cutting back its bond portfolio by about $95 billion per month (only about 1% of its holdings each month) by not purchasing new securities to replace maturing bonds. The balance sheet dropped to roughly $8.5 trillion, down less than 6% from its peak in April, 2022.⁹

The process of the Fed “unwinding” its balance sheet is commonly referred to as quantitative tightening. “This means the Fed is putting less liquidity in the market, requiring other investors to generate demand for bonds,” says Bill Merz, head of capital market research at U.S. Bank.

The Fed added liquidity to the banking sector after several regional banks ran into problems beginning in March 2023. The most recent issue arose when another regional institution, First Republic Bank, faced a potential collapse and was acquired by a larger bank. Concerns about additional bank problems, particularly among regional banks, have added volatility to the markets.

Bond markets respond to events

The interest rate environment across the broader bond market has changed dramatically since early 2022. In October 2022, yields on the benchmark 10-year U.S. Treasury note rose above 4%, the first time since 2010. Yields on 10-year Treasuries moderated after that point, but again topped 4% in early March 2023. In an unusual occurrence, yields on shorter-term Treasury securities are higher than the yield on 10-year and 30-year bonds. At the in late May 2023, the yield on 3-month Treasury bills stood at 5.40% and yields on 2-year Treasury notes at 4.29% compared to a yield of 3.72% on 10-year Treasury notes. This contrasts with normal circumstances, when investors demand higher yields for bonds with longer maturities.

Source: U.S. Department of the Treasury, Daily Treasury Par Yield Curve Rates. May 2023 number as of May 22, 2023.

Inflation remains a challenge

Despite the Fed’s dramatic strategy shift, inflation remains its primary concern. Haworth points out that the economic impact of rate changes can take time. “Each rate hike will take six-to-12 months to work its way into the economic engine.” That may be, at least in part, why inflation rates have yet to ease significantly despite the Fed’s drastic policy shift. Haworth notes that higher mortgage rates have slowed activity in the housing market and may just be starting to affect other forms of borrowing, such as business capital investments. “Corporations that could more easily realize a payback from an investment that required borrowing at a 3% interest rate may find less financial viability today having to borrow at interest rates of 5% or more.”

With the Fed maintaining its focus on fighting inflation, concerns grow that its actions will ultimately lead to a recession. “There’s a growing expectation that corporate earnings will suffer if the economy slows, and that factor was not priced into the stock market during its earlier setbacks in 2022,” says Haworth. “How slow the economy will get depends in part on events that are going on around us. For example, if inflation suddenly spikes up again, that could create more challenges.”

Will the investment environment change?

As the Federal Reserve approaches the peak in its current interest rate-hiking cycle, how should investors assess the current opportunity in the markets?

• Fixed income market. Today’s higher interest rates make fixed income securities more attractive. “It’s very unusual for bond markets to decline in two consecutive years, so there may be an appealing opportunity in bonds in 2023 and beyond,” says Haworth. Investors may consider a focus on high quality investment-grade taxable and municipal bonds. However, if rates continue to rise in the near term, bond prices could decline further. Consider including positions in short-term U.S. government bonds as part of a diversified fixed income portfolio. Short-term bonds are less sensitive to interest rate changes and can help mitigate price sensitivity in a portfolio should interest rates continue to rise.
• Real assets. This category typically benefits from a persistently elevated inflationary environment. Opportunities to consider center on global infrastructure assets which include utilities, transportation, communications, midstream energy and pipelines.
• Equity markets. The environment for stocks may remain volatile in the near term. Investors may reset earnings expectations if the Fed’s monetary tightening contributes to slow economic growth, with recession risks still a consideration. There are concerns about how higher costs, rising interest rates, less available capital and a potential decline in consumer spending will affect the bottom lines for many corporations. “Investors who have assets to deploy in the equity market should consider dollar-cost averaging over a period of time (consistently investing over at least a six-month period),” says Haworth. This systematic investment approach has the potential to lessen the risk during volatile market periods, while still allowing investors to put money to work in equities to meet long-term goals.

Be sure to consult with your financial professional to review your current portfolio positioning and determine if changes might be appropriate given your goals, time horizon and feelings toward risk.