The Fed raises rates – let the inflation battle begin

• As expected, today (March 16) the Federal Reserve raised the benchmark federal funds rate by 0.25%, the central bank’s first hike since 2018¹. The FOMC also outlined in its "dot plot" an expectation for six additional rate hikes this year, bringing the federal funds rate potentially around 2.0% this year, largely in-line with market expectations. In addition, the Fed expects to announce a balance sheet reduction program "at a coming meeting," perhaps as early as May. While Fed Chair Jerome Powell noted the crisis in Ukraine has added some uncertainty to its outlook, the committee felt compelled to start raising rates to fight the growing inflationary pressures that are now also emerging from the crisis.

• The Fed highlighted that the U.S. economy remains relatively healthy and can likely absorb rate hikes. Jerome Powell underscored in his comments that "the economy is very strong and well positioned to handle tighter monetary policy." The unemployment rate in the U.S. is now at 3.8%, and labor force participation has slowly starting to climb, with pandemic trends continuing to improve. In our view, the Fed tightening cycle and geopolitical crisis come at a time of relative strength in the U.S. economy, with elevated levels of consumer savings and healthy household balance sheets.
  
  We would also highlight the Fed’s updated economic projections. They have decreased their growth forecast and increased core PCE inflation forecasts meaningfully for 2022. Nonetheless, the growth expectation of 2.8% remains well above historical averages of 1.5%-2.0%, with no indication of recession on the horizon. The core PCE inflation is also expected to drop to 2.6% by next year from 4.1% in 2022.
  
  The Federal Reserve Summary of Economic Projections, March 2022

This table shows a comparison of 2022 to future expected growth in key indicators for the economy and the Federal Reserve. The general trend is that the labor market remains resilient and inflation is likely to come down with tighter monetary policy.

• In our view, the Fed will now hike rates at a steady pace, likely in 0.25% increments, through at least the next four meetings. If inflation or growth slows meaningfully, though, the Fed then has scope to move at a more gradual pace. Overall, we believe the Fed was prudent to set the bar at seven rate hikes for the year and could come in under this as conditions evolve.
  
  While Fed rate-hiking cycles push borrowing costs higher for both consumers and corporations, there has been historically a lagging impact from this tightening. On average, the U.S. economy tends to slow in the second year after tightening, entering recession (if there is one) about 24 months after the start of Fed tightening.¹ In addition, over the last five Fed tightening cycles, markets have performed well.

The S&P 500 has performed well on average over the past five rate-hiking cycles, averaging 6% six months after the first hike, 5% after 12 months and 12% from the first to the last rate hike.

Source: FactSet. Past performance does not guarantee future results. Market indexes are unmanaged and cannot be invested into directly.

• Markets entered the year with uncertainty around the path of the Fed and then the geopolitical crisis in Ukraine; investors now have more clarity from the Fed. After a 10% pullback in equity markets this year, we would expect a rebound in markets after more clear direction from the Fed, as well as growing hope for a de-escalation of the Ukraine crisis¹.
  
  If markets can climb these walls of worry, investors may have an opportunity to add quality investments at better prices, especially if the economy continues to grow at a healthy pace. We could see a reversal in some traditional safe-haven assets such as gold and the dollar, as well as in commodities. We also would look for better performance from U.S. large-cap equities, particularly those with a value and cyclical tilt, and perhaps some exposure to areas of the market poised to benefit from reopening.

^{1 Source: Ned Davis Research.}

Takeaways for investors

• Today’s FOMC meeting offered investors more clarity around the path of the Federal Reserve, at a time when hope is rising for a de-escalation in the Ukraine crisis. This potential clearing of two overhangs may set markets up for a rebound, providing investors the opportunity to add quality investments at better prices.
• After a 10% pullback in markets and largely defensive positioning by investors, we could see a reversal in some traditional safe-haven assets and commodities, as well as better performance from those parts of the market that have underperformed the most. We continue to favor large-cap U.S. equities, particularly those with a value and cyclical tilt, and exposure to reopening of the economy.
• While Fed rate hikes can tighten economic conditions, we don’t see a U.S. recession over the next year. And though we may see periods of elevated market volatility, markets have historically performed well during Fed tightening cycles. Investors may use volatility as opportunities to add to, rebalance or diversify portfolios.

Mona Mahajan,
Investment Strategist

^{Source: FactSet}