Lord Abbett: Will The Fed’s “Front-Loaded” Rate Moves Tame Inflation?

In its attempt to bring inflation to heel, the U.S. Federal Reserve (Fed) administered a second strong dose of policy medicine on July 27. The Federal Open Market Committee (FOMC), the Fed’s policy-setting arm, raised the target interest rate by 75 basis points (bps), the fourth increase of the current tightening cycle and the second consecutive policy move of that size. (The last time the Fed implemented back-to-back 75-bp hikes was in the early 1980s.) The Fed had widely been expected to replicate its June hike since the release of the June U.S. consumer price index (CPI), which showed overall year-over-year headline inflation running at 9.1%.

Fed Rate Hikes, Inflation & Recession Risk: Resources for Investors

After boosting the fed funds target range to 2.25%-2.50%, the FOMC reiterated in a post-meeting statement that it anticipates that “ongoing increases in the target range will be appropriate.”

The Fed nodded to the economic deceleration it has been trying to engineer, noting that “indicators of spending and production have softened.” Counterbalancing that softness, “job gains have

been robust in recent months, and the unemployment rate has remained low.” After a dissent from Kansas City Fed President Esther George at the June meeting, the Fed’s decision on July 27 was unanimous, suggesting a greater agreement on the need to mount a forceful near-term response to return inflation to its 2% target; the Fed noted that “supply and demand imbalances related to the pandemic, higher food and energy prices, and broader price pressures” continue to drive indicators such as the CPI higher. That said, the FOMC is prepared to change tack “if risks emerge that could impede the attainment of [its] goals.”

Financial markets rallied in late trading on July 27 on expecta- tions that the series of outsized rate hikes would come to an end. According to Bloomberg, swap markets priced in around 58 bps of tightening for the next meeting in September, with the expected peak in the fed funds rate for the cycle dropping to around 3.3% in late 2022–early 2023.

Policy & Investment Implications

By acknowledging that its policy has started to have the desired effect on activity, and that there are more rate hikes in the pipeline, the Fed may be implying that it might not need, ultimately, to tighten as much as it may have thought before. While Powell said that another outsized rate increase at the September meeting was possible, ultimately, “nothing has been decided as of yet.” In our view, that may open the door to a 25-bps hike in September, especially if the data continue to show some weakness. Strong labor market data has been one of the primary reasons why the Fed feels it could continue tightening even in the face of the softening in spending and production. Any continuation of recent slowing in labor market activity – as measured in upcoming reports on employment costs and nonfarm payrolls – may prompt the Fed to reconsider the pace of tightening.

Where does this leave the Fed now? We think that the FOMC was clearly uncomfortable with rates below their estimate of its neutral rate in this environment. If rates are below neutral, monetary policy is stimulating the economy to faster growth, which would be inappropriate amid elevated inflation. And the Fed has acted aggressively, raising rates 225 bps since March, to get back to neutral. If rates are at neutral, and if the Fed really believes that further rate increases will be restrictive, it may rethink how aggressively it will move in the future.

In the medium term, high inflation is the bigger risk for markets. If investors believe the Fed is ultimately on a path towards control of inflation, then it is logical to expect that the Fed will execute monetary policy accordingly. That would be positive for risk premia, in our view; quelling inflationary fears through aggressive actions in the short term should tighten risk premia. The fact that policymakers, while still considering an outsized move in September, may be amenable to a much smaller move should conditions warrant, is potentially positive for risk assets.