The End of the Fed's Tightening Cycle Nears

Today, the Federal Reserve raised the Fed funds target range by 25 basis points (bps), to 4.75%–5.00%, as expected, and signaled it expects at least another 25 bps of additional rate hikes will be necessary to bring down inflation. This announcement and the recent turmoil in the banking sector increase our confidence that the Fed is nearly done tightening.

Since the Fed’s previous meeting in early February, both inflation and economic data have been surprisingly strong. The US Core Consumer Price Inflation Index rose 5.5% year-over-year in February. However, recent turmoil in the banking sector suggests more cyclical pockets of the economy are beginning to crack following last year’s sharp rise in rates. As a result, there has been significant uncertainty about the path of monetary policy, as investors wrestled with how central banks might respond to potentially competing concerns of financial stability and price stability. In the last few weeks, rates markets swung from expecting the Fed would raise rates approximately 100 bps more this year before pausing, to pricing in that the Fed was done hiking and would soon begin cutting rates.

In theory, central banks have the tools to address both financial stability and price stability concerns. Right now, policymakers appear to be testing that theory given today’s decision by the Fed, last week’s decision by the European Central Bank to raise rates 50 bps, and steps taken by regulators in recent weeks to provide liquidity to struggling banks. Earlier this week, US Treasury Secretary Janet Yellen even signaled the US government may offer additional support to smaller banks, if needed.

However, in practice, the line between these competing objectives isn’t as clear. While we do not expect the current banking crisis to pose a systemic risk to the economy, we would not be surprised to see other more vulnerable small or mid-sized US banks require support. Even if policymakers successfully reduce financial stability risks, we expect banks will remain under pressure from higher rates and that recent stress will lead to a further tightening in credit conditions; both will likely be negative for economic growth.

As such, recent events have increased our confidence that we are nearing the end of the Fed’s tightening cycle. However, while we still expect the Fed to pause rate hikes this year, the bar for the Fed to cut rates aggressively, as the market expects, remains high, given the elevated level of inflation. Now is a time to manage risk thoughtfully and keep equity allocations and bond duration in line with policy targets.