The Federal Reserve raised its benchmark policy rate by 0.75 percentage points for the second month in a row this week as it doubled down on its aggressive approach to taming soaring inflation despite early signs the US economy is starting to lose steam. At the end of its two-day policy meeting, the Federal Open Market Committee lifted the target range of the federal funds rate to 2.25 per cent to 2.50 per cent. The decision, which had unanimous support, extended a string of interest rate increases that began in March and have ratcheted up in size as the Fed’s battle to fight inflation intensifies.
The rate rise means the central bank is in the throes of the most aggressive cycle of monetary tightening since 1981. It follows a half-point rise in May, and a 0.75 percentage-point rise last month — the first of that magnitude since 1994. With inflation running at its fastest pace in more than four decades (circa 8.5%), further rate rises are expected well into the second half of 2022, but the pace of those increases is hotly debated. Economists are split over whether the Fed will implement another 0.75 percentage point rate increase at its next meeting in September or opt for a half-point rise.
In a press conference following the decision, Jay Powell, Fed chair, said that as the central bank continues to tighten policy, “it likely will become appropriate to slow the pace of increases” while policymakers assess how rate rises are affecting the economy and inflation. Those remarks prompted a market rally, with the blue-chip S&P 500 index rising 2.6 per cent and the tech-heavy Nasdaq gaining 4.1 per cent. The two-year Treasury yield, which moves with interest rate expectations, was 0.08 percentage points lower at 2.97 per cent.
Goldman Sachs Asset Management, said: “We’re past peak hawkishness . . . their speed going forward will be slower.” However, Powell said the Fed would shift to a “meeting-by-meeting” approach to setting policy and that “another unusually large increase could be appropriate” at the September meeting. He added that the committee “wouldn’t hesitate” to implement a sharper rise if warranted by economic data. Inflation remains the Fed’s number one priority and they’re willing to sacrifice growth to achieve it.”
The Fed chair warned a period of slower growth and a weaker jobs market might be needed to bring down high inflation. Indeed, yesterday we also had the release of US GDP figures for the second quarter which showed that the world’s biggest economy contracted at a 0.9 per cent annualised rate, much worse than expectations of a 0.5% rise. The unexpected fall came after GDP declined at a 1.6% rate in the first quarter. Two straight months of contraction meet the technical definition of a recession but investors believe the US is not currently in a recession, and the reason is that there are just too many areas of the economy that are performing too well.
Still weaker economic growth has slightly weakened future interest rate rise expectations. With the current federal funds rate range 2.25 per cent to 2.50, expectations are that the rate will reach about 3.5% later this year. Most officials believe interest rates must be come restrictive to tame inflation running at circa 8.5% well above the Fed’s 2% target.
Indeed the 2-year US Treasury Bonds are a very good indication of interest rate expectations and are currently trading at 3.0% yield-to-maturity. Similarly, 10-year US Treasury yields are close to 3% YTM although in mid-June yields reached 3.5%.
Stock markets have fallen hard this year with the US NASDAQ index down around 30% last month and the US S&P index down 20% but markets have rallied in July to regain about 5% of such losses.
The US Dollar remains at 20-year highs supported by the strong US interest rate regime. Note: Europe and the UK have inflationary problems and levels similar to the US but are not able to raise interest rates as aggressively as the US mainly due to weaker economic outlooks which again explains the strength of the US Dollar.
OIL is trading at circa $105 per barrel torn between two forces. On the one hand, reduced energy supplies principally from Russia drove oil up to $140 per barrel a couple of months ago but oil has fallen back due to the threat of a US/global recession and the reduced demand for oil that implies.
GOLD normally performs well in inflationary times but does not perform well if interest rates go up and investors can get secure high returns from bonds (with gold a non-interest-bearing asset). So gold is trading well below its Covid crisis highs of $2,050 per ounce at $1,720 p.o.
Investors’ attention will continue to centre on the level of inflation and the strength or not of the US economy to give us our next market direction.
