Overnight, the Federal Reserve raised its fed funds rate aggressively again by 75ps to 2.25-2.50% to curb inflation. This year the Fed has increased interest rates in the same rapid manner as it did in 1994, the last time it lifted fed funds by 75bps as the first chart shows.
Source: Bank of Singapore, Bloomberg.
The Fed’s decision was expected and returned the fed funds rate to ‘longer-run’ neutral levels that officials believe neither stimulate nor restrict the economy, as the second chart shows. But financial markets rallied when Chairman Powell said: ‘at some point it will be appropriate to slow down [the pace of hikes] … we might do another unusually large increase [of 75bps in September] but that’s not a decision that we’ve made at all, we’re going to be guided by the data.’
Source: Bank of Singapore, Bloomberg.
We think it’s still too early for the Fed to turn dovish and declare victory. Powell said the Fed would need to see ‘compelling evidence’ inflation at 9.1% is falling. He also said: ‘the US is not currently in a recession.’ We thus expect the Fed will still hike by 50bps each in September and November before pivoting to moderate 25bps hikes only in December and January. We therefore see fed funds reaching 3.75-4.00% early next year, levels that should ‘restrict’ activity and slow inflation.
Over the next few months, financial markets are thus likely to remain volatile - to the benefit of the safe-haven USD - until inflation eases. But once the Fed can shift to moderate rate hikes towards the end of 2022, risk assets should bottom out and start rallying as occurred at the end of 1994 when that year’s rapid rate hiking cycle neared its end.
Banner image source: AFP.
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