The Open Market Committee of the Federal Reserve (FOMC), the body that determines monetary policy, to include the direction of interest rates, concluded a regularly scheduled two-day meeting this past Wednesday during which they decided that a 0.75% increase in the Federal Funds rate was necessary to combat the recent surge in inflation. This can be defined as the rate charged between member FDIC banks for overnight loans of excess reserves and is the foundation from which many other rates of interest are predicated upon.
The latest marks the third consecutive increase. At the conclusion of the March 15-16, May 3-4 and June 15-16, 2022 meetings the Fed announced rate hikes of 0.25%, 0.50% and 0.75%, respectively. The latter marks the largest hike since 1994. Of interest is the fact that 1994, a year in which the Fed hiked the fed funds rate six times and in which the S&P 500 dropped 1.54%, set the stage for the second half of the 1990s. During this five year stretch the S&P 500’s worst year was one in which it increased a little over 20% and had a compounded annualized growth rate of 26.18%.
The official Federal Reserve Press Release noted the obvious, that “inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures.”
The statement also made reference to its statutory dual mandate which is to pursue maximum employment along with price stability, the latter of which is defined as an annual inflation rate of two percent.
To nobody’s surprise, it is price stability that has the Fed in a bind. As is measured by the Consumer and Producer Price Indexes, retail and wholesale inflation increased by 1.0% and 0.8% during May and by 8.6% and 10.8% over the trailing twelve months. In addition, housing prices have surged by more than twenty percent over that same time frame, five times the historic average.
Several months ago, prior to the invasion of Ukraine by Russia or China’s imposition of its “zero tolerance” policy in regard to addressing COVID in the country, we coined the word “seculatory” to describe our take on the nature of the inflationary pressures impacting the consumer. We believed then that some of these would be somewhat temporary while others would be longer lasting. Given the two unforeseen events noted at the head of this paragraph, we are currently of the belief that inflation will be somewhat longer lasting than we initially foresaw, but ultimately at less than half its current pace. We also believe that barring an additional black swan event, inflation will be peaking within the third quarter as the drag resulting from higher interest rates along with Quantitative Tightening begins to take hold.
A case for this can be illustrated by taking a look at mortgage rates. According to Bankrate, the average rate on a 30-year conventional fixed mortgage is hovering near 6%. Assuming a mortgage of $350,000, the monthly payment would have increased $622 or by $7,464/year as compared to one year ago when the interest rates charged on that same mortgage was averaging 3%.
Although we sincerely applaud the Fed’s recent stance on fighting inflation, in our opinion the Fed has to be careful to not tighten too much as monetary policy works with a lag. In addition, higher interest rates will do little to correct the disruptions in the supply chain other than through demand destruction. Too much of which will prevent the Fed’s much sought after soft landing. The Fed next meets on July 26-27 and then again on September 20-21. At this time we expect increases in the Fed Funds rate of 0.50% at each, but are hopeful that between now and September enough evidence of economic softening will have accumulated to necessitate only a 0.25% hike during that meeting.
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