US Fed raises rates: how does this impact our outlook and what risks lie ahead?

Key takeaways
We review the US Federal Reserve’s decision to raise interest rates and assess what that means for our outlook.
What happened?
The Federal Open Market Committee (FOMC) released its statement following the March meeting, and US Federal Reserve Chair Powell held his regularly scheduled post-meeting press conference.
As anticipated, the FOMC increased the Fed Funds Target Rate2 by 25 basis points (bps), with James Bullard the sole dissenter preferring to raise by 50bps. References to the balance sheet were limited, with the Fed explaining that “the Committee expects to begin reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities at a coming meeting.”
There were some significant changes in the Summary of Economic Projections, compared to the December 2021 meeting.
The Fed revised its forecast for 2022 real GDP growth to 2.8% from its December 2021 forecast of 4.0%. The median forecast for 2022 core personal consumption expenditure3 (PCE) inflation increased to 4.1% from 2.7%. This has prompted the FOMC to adjust its 2022-end target for the Fed Funds Target Rate to 1.9% from 0.9%, with the highest individual forecast (presumably Bullard) at 3.1% by the end of 2022.
We welcome the increase in inflation forecasts by the FOMC, which is a reasonable step to move closer to what we are seeing in the data and prepare the ground for further revisions if necessary for 2023.
During the press conference, Powell made some key points:
- The robustness of the labour market, highlighting that it is “extremely tight”, with wages rising the fastest in many years
- Risks to inflation remain to the upside
- The FOMC has “made good progress” in discussing the future of the Fed’s holdings of Treasury and mortgage-backed securities
- The Committee’s view that the US economy is strong, and well placed for a tightening in monetary policy4. He also believes that a recession in 2022 is unlikely
- He reinforced the idea that balance sheet reduction can be thought of in terms of interest rate increases, prioritising price over quantity analysis
- Balance sheet reduction will “be faster than last time”, “earlier in the cycle than last time”, and “will look familiar”
What is our take on what is happening?
What we are experiencing is the unwinding of the “dash-for-cash” phenomenon that occurred in 2020. At the height of uncertainty related to the Covid-19 pandemic, investors de-risked portfolios and demanded to hold more liquid assets, including higher money balances. The Fed rightly accommodated this shift in investor demands, but grossly overestimated how accommodative they could be without affecting future inflation.
As consumer behaviour and spending has normalised, these excess money balances have been reflected in a strong economic recovery in the US, and ultimately accelerating inflation. The transitory explanation of inflation that was endorsed by the Fed has fallen away as inflation has broadened out throughout the US economy.
What is our outlook?
In our view, the Fed is attempting to “thread the needle”, by trying to limit the rise in long-term inflation expectations amid several notable headwinds for global economic growth. The most notable is the war in Ukraine and the zero-Covid policy in China. Three scenarios are possible:
- The Fed achieves its desire for a “soft landing”, with inflation returning to 2% relatively quickly, growth affected only marginally, and a terminal Fed Funds Target Rate in line with their projections;
- The Fed delays the required degree of tightening as a commodity price shock dramatically slows growth, and the US enters a period of stagflation;
- The Fed tightens too aggressively, facilitating a more conventional deflationary recession in 2023.
Our base case (based on current forward guidance from the Fed) remains firmly in the first scenario, but risks have increased recently.
History suggests that despite some initial volatility, stocks tend to outperform bonds once the Fed starts new tightening cycles. The FOMC’s projections portray the desire to remove the generous policy support provided since the outbreak of the pandemic, especially with inflation running higher than previously expected.
The removal of support is likely to keep Treasury yields moving higher, although a flattening of the yield curve is likely to dampen the effect on longer maturities. It would not be a surprise to see 10-year yields above 2.5% this year, though after recent strong gains, a period of consolidation may be in order.
Higher yields may be expected to support the dollar, but it has already strengthened over the last year, even more so since Russia’s invasion of Ukraine. We wouldn’t be surprised to see the greenback consolidate over the rest of the year.
Within equities, value stock tends to outperform growth stock when inflation is high and falling, as cyclicals do over defensives. Alternatives such as real estate and private credit, as well as commodities, could also outperform in this environment.
US treasuries and high-quality investment grade bonds may be worth watching should the Fed decide to “slam on the brakes” and a recession ensues (where both growth and inflation fall).
What are we looking out for? What are the risks to our view?
The primary risk to the markets in 2022 is if the Fed makes a policy error by engineering a fully contractionary monetary policy in response to persistent, above-target inflation. This would likely result in a recession in 2023. We will follow a variety of incoming data, including inflation and inflation expectations, that could trigger more aggressive monetary policy.
Furthermore, the war in Ukraine has significantly increased the chances of a stagflationary scenario, although this is not our base case.
Footnotes
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1
The Federal Funds Target Rate is the target interest rate set by the Federal Open Market Committee.
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2
The Federal Funds Target Rate is the target interest rate set by the Federal Open Market Committee.
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3
The personal consumption expenditure price index is one measure of US inflation. It tracks the change in prices of goods and services purchased by consumers throughout the economy.
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4
Central banks tighten monetary policy by raising interest rates to slow overheated growth or to manage inflation.
Investment Risk
The value of investments and any income will fluctuate (this may partly be the result of exchange-rate fluctuations) and investors may not get back the full amount invested.