Federal Reserve focuses monetary policy on fighting inflation

Source: U.S. Bank Asset Management Group

Fifteen months after it first made a dramatic policy shift, the Federal Reserve (Fed) held the line on the key interest rate it controls. At the June 2023 meeting of the policy-making Federal Open Market Committee (FOMC), they maintained their target federal funds rate in a range of 5.00% to 5.25%. Although this pause may demonstrate growing Fed confidence in its battle to bring down inflation, Fed chair Jerome Powell made clear that more rate hikes are possible at upcoming meetings.

The Fed also retained 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 is trimming its balance sheet of those assets, from its peak near $9 trillion.¹ This so-called “quantitative tightening” approach, combined with higher interest rates, is designed to temper inflation by slowing economic growth through higher borrowing costs.

Cost of living increases, a virtual non-issue for decades, became a dominant concern for consumers in early 2021 and despite significant improvement, remains an issue today. In testimony before Congress in June 2023 Powell stated “We have been seeing the effects of our policy tightening on demand in the most interest-rate sensitive sectors of the economy. It will take time, however, for the full effects of monetary restraint to be realized, especially on inflation.”²

The Fed’s decision to pause its string of interest rate hikes may reflect a desire to assess additional economic data before further moves are made, according to Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “Given the long and variable lag between rate hikes and economic results, it seemed reasonable to Fed officials to take some time to see how things are working so far.” Haworth notes ample Fed progress to temper the inflation threat that first emerged in 2021.

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 at its May 2023 meeting, raised rates for the tenth consecutive time, adding up to a 5% rise in the fed funds target rate. It currently stands at its highest level since October 2007.³

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 May 2023, living costs (as measured by the Consumer Price Index) rose 4.0% over the previous 12 months, a decline of 5.1% from the peak inflation level reached in the 12-month period ending in June 2022. Powell has stated, “we remain strongly committed to bringing inflation back down to our 2% goal.”⁴ Powell adds 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,”5 considered a signal that the Fed is not ruling out the possibility of further rate hikes.

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) 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 for the current cycle

Following its June 2023 meetings, indications from the Fed are that two more rate hikes could occur in the coming months. “The market is clearly pricing in the expectation of additional rate hikes,” says Haworth. “Perhaps more important is that the Fed is not likely to bring rates below current levels anytime in 2023.” Earlier in the year, many market analysts forecast Fed rate cuts yet this year, but echoing chair Powell’s comments, Haworth believes the Fed will be cautious about trimming rates quickly. “To this point, the economy is avoiding a recession. If that persists, there will be less pressure on the Fed to quickly shift course on monetary policy. The focus will continue to be on managing the inflation threat.”

The intended impact of higher interest rates is to slow the economic activity, and in turn, slow the inflation rate. 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 4.3% for the 12 months ending in May 2023, down slightly from previous levels.⁶ Haworth believes the Fed sees wage growth as an important measuring stick to determine its inflation-fighting progress.

Powell appeared to solidify the Fed’s determination to quell the inflation threat, even though economic hardship may result. In comments after the May 2023 FOMC meeting, 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.”⁴

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 $8.3 trillion, down less than 7% from its peak in April, 2022.⁷

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, contributed to market volatility earlier in 2023.

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 end of May 2023, the yield on 3-month Treasury bills stood at 5.52% and yields on 2-year Treasury notes at 4.40% compared to a yield of 3.64% on 10-year Treasury notes. This contrasts with normal circumstances, when investors demand higher yields for bonds with longer maturities.

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-24 months to work its way into the economic engine.” That may be, at least in part, why inflation rates remain above the Fed’s long-term 2% annual target despite the Fed’s significant interest rate hikes.

Will the investment environment change?

As the Federal Reserve approaches what could be the peak in its current interest rate-hiking cycle, where can investors find the most attractive opportunities in the markets? In recent weeks, a return to more neutral portfolio positioning appears to be appropriate for many investors:

• 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. While higher yields can be earned in short-term debt instruments, it’s important to manage total portfolio duration by including long-maturity U.S. Treasuries to position a portfolio for the long term. Investors should consider taking some credit risk in certain sectors to enhance portfolio income. We would include active managers focused on high quality loan obligations and residential mortgage back securities not backed by a government agency. Certain investors could also consider insurance-linked securities such as catastrophe bonds which are less correlated to the economic environment.
• Equity markets. The environment for stocks may remain volatile in the near term, but the risk-reward dynamic has improved in recent weeks. Corporate profits, a key concern during the first half of 2023, appear to have stabilized. Equity markets seem more attractively positioned than has been the case recently. “Investors who have assets to deploy in the equity market may wish to 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.