The U.S. Federal Reserve’s (Fed) aggressive campaign to keep inflation in check brought yet another outsized rate hike on September 21, with the prospect of more such moves still to come. At the conclusion of its two-day policy meeting, the Federal Open Market Committee (FOMC), the Fed’s policy-setting arm, raised the target interest rate by 75 basis points (bps), the third consecutive policy move of that size and the fifth increase of the current tightening cycle.
After boosting the fed funds target range to 3.0%-3.25%, the FOMC reiterated in a post-meeting communique that it anticipates that “ongoing increases in the target range will be appropriate,” a direct lift from its July statement.
The Fed noted signs of “modest growth in spending and production.” The persistent strength of the labor market was evident as the Fed again characterized job gains as “robust,” with low unemployment.
With the August consumer price index (CPI) report showing core and headline inflation running above expectations, the Fed has administered a heavier dose of policy medicine in order to return inflation to its 2% target; the September statement again 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. Once again, policymakers are prepared to alter their course “if risks emerge that could impede the attainment of [its] goals.”
But for now, the Fed remains resolute. The quarterly “dot plot” projections issued by the FOMC indicated median fed funds rate of 4.375% at the end of 2022—a 125-bp increase from the September level – and 4.625% at the end of 2023. That was a more hawkish policy tilt than investors expected, as futures markets had priced in a terminal rate of 4.5% in early 2023, falling back to 4.125% at yearend. That signals another 75-bp move could well be in the offing at the November FOMC meeting.
FOMC members’ projections also indicated that bringing inflation down would be harder than previously anticipated. Despite weaker growth, higher unemployment, and higher rates than indicated in the June Summary of Economic Projections, the inflation forecast at 2023 year-end was revised up from 2.6% to 2.8% (2.7% to 3.1% excluding food and energy).
In a post-meeting press conference, Fed Chair Jerome Powell indicated there were tentative signs of inflation and labor market pressure easing. He also said that if data indicated that inflation was on a downward trajectory to 2% by 2024, policy might even be eased. Unfortunately, inflation has consistently surprised to the high side and has remained stubbornly above the Fed’s forecasts.
Powell also noted that the U.S. economy is still resilient despite weakness in rate-sensitive sectors, implying that bringing inflation back down by restricting aggregate demand could be more difficult than previously thought.
Investment Implications
How might investors respond to a backdrop of persistently high inflation, rising rates, and the prospect of a continued aggressive policy response from the Fed as it tries to administer an appropriate dosage of their medicine? It seems clear to us that volatility will remain elevated for some time as the market wrestles with new and conflicting economic forces. However, as we have said before, shorter duration assets can hold up well when inflation is a problem, due to the simple mechanics of shorter-dated investments maturing quickly and then being reinvested at higher yields. Short duration assets also have the added advantage of historically lower price volatility. As uncomfortable as rate hikes have been for some of these investments, those hikes now translate to much higher expected returns going forward, meaning that as a place to ride out the storm, such investments provide an intriguing tradeoff of attractive expected returns versus relatively low price volatility.
