The Federal Reserve announced that it was raising the target range for the Fed funds rate by 75 basis points (bps) to 1.50%–1.75%. An apparent briefing to the financial press last week meant that this course of action was fully priced in by the rates market beforehand, despite just 50 bps being priced as recently as late last week. Chairman Jerome Powell indicated that the Fed currently expects to deliver either a 50 bp or 75 bp hike at its next meeting.
The Fed also made wholesale changes to its summary of economic projections. Even as the Fed left its median estimate of the neutral Fed funds rate broadly unchanged at 2.5%, the median estimate of the terminal rate to be reached this cycle increased sharply from 2.8% to 3.8% in 2023. The projections also indicate that while the Fed funds rate may decline in 2024, at 3.4% the Fed still expects it to remain firmly in what it views as restrictive territory. In sum, the Fed clearly now believes that a more materially restrictive rate policy is required to bring inflation back toward target. Consistent with this, the Fed’s latest projections also show substantially lower GDP growth estimates than the March figures, for 2022 (down 1.1 percentage points [ppts] to 1.7%) and 2023 (down 0.5 ppts to 1.7%). Additionally, unemployment is projected to rise 0.5 ppts between now and the end of 2024.
The more aggressively restrictive course of action now planned by the Fed was driven by a deterioration in the inflation data released last week. The annual rate of inflation for May surprised considerably to the upside, coming in at 8.6%, the highest reading since 1981. What’s more, the University of Michigan survey of consumer inflation expectations continued its ascent, with long-term inflation expectations having now risen to 3.3%. The latter outcome may have raised worries within the Fed that the risks of a self-reinforcing inflationary environment are rising, particularly given the tightness of the labor market.
Bonds and equities, which had priced in some risk of a steeper tightening track, both rallied in response to the Fed decision. Two-year and ten-year Treasury yields declined 25 bps and 16 bps, respectively, to close at 3.20% and 3.33%. Still, these benchmark bond yields are 67 bps and 48 bps higher month-to-date. The S&P 500 Index returned 1.5% on the day but remains 8.2% down on the month. Finally, the broad dollar weakened modestly but stands approximately 3% higher on the month.
The Fed’s projections indicate it believes it will be able to achieve that rarest of outcomes, a soft landing. Tighter financial conditions, a sizeable fiscal drag, and the impact of elevated inflation will all challenge this goal. Indeed, historically, the unemployment rate has never risen over a two-year horizon, as now projected by the Fed, outside of recessionary periods. With material tightening priced into bonds, the attractiveness of US Treasuries has improved in recent weeks. Nonetheless, the tight labor market, Russia’s war in Ukraine, and Chinese COVID-19 policies look set to keep inflation volatility elevated. Therefore, we recommend that investors that are short duration should move toward a neutral position.