The End is Not Imminent for This Rate Hiking Cycle

As expected the Federal Reserve (Fed) increased its key interest rate by 25 bps to a target range of 4.5 – 4.75%. The 25 bps increase is a pullback after the central bank increased rates by 50 bps during its previous FOMC meeting and 75 bps during the four meetings previous to that. While year-over-year inflation has slowed to 6.5%, the economy remains “modest”, and the labor market remains tight. The 25 bps hike was largely priced into markets as the S&P 500 rose just over 1%, while the tech heavy Nasdaq 100 rose over 2% and the Russell 2000 index rose over 1.5% on the day.

Despite the slower pace of hikes and softening inflation, the Fed stated that “ongoing increases” are needed and “a couple more” are likely this year. While investors are looking for signs that the Fed is ready to put an end to this rate-hiking cycle, the statement did them no favors. Statements like “ongoing increases” disappointed some as the Fed remains committed to bringing inflation down to its 2% target  and is not ready to signal an end is near for this cycle.

As for inflation, the Fed statement read, “Inflation has eased somewhat but remains elevated”, however, the statement did not mention supply/demand imbalances. Fed Chairman Powell also said “while recent developments are encouraging, we will need substantially more evidence to be confident that inflation is on a sustained downward path” during his post-meeting press conference.

During its December meeting Fed officials forecasted the terminal rate will reach 5.1%, however, as of Tuesday, markets are forcasting interest rates will peak at 4.9%. In a response to a question about the terminal rate, Powell stated it’s “possible” that the fed funds rate could stay below 5%, but also said it is unlikely the Fed will cute rates this year unless inflation declines rapidly. 

While the Fed’s decision and statement didn’t provide a signal that an end to its rate-hiking cycle is imminent, as more work is needed to tame high inflation, there is a sense that we will see an end to this cycle by summer. I believe the Fed will hike rates 25 bps two more times before giving pause. January’s equity rally shows that markets are expecting a dovish pivot from the Fed in the months ahead. However, if Powell and the Fed surprise by extending this rate-hiking cycle by more then two 25 bps hikes this year, we could see a spike in volatility and another sell-off in equities with yields surging higher, particularly on the short of the curve.