Federal Reserve recalibrates monetary policy to fight inflation

November 8, 2022 | Market news

Key takeaways

  • The Federal Reserve continues to aggressively pursue efforts to stem the tide of higher inflation by slowing the economy.
  • Key policy changes in 2022 include significant interest rate hikes and a reduction in the Fed’s asset holdings.
  • Can the Fed achieve its inflation-cutting objectives without causing the U.S. economy to tip into a recession?

The Federal Reserve (Fed) has aggressively pursued a new, tighter monetary policy in 2022 as its primary strategy to deal with persistently higher inflation. The Fed revised its stance in recent months after nearly two years of an “easy money” policy. The prior policy included extremely low interest rates and significant intervention in the bond market. The Fed’s new approach reverses its monetary strategy and does so in an aggressive fashion.

Since March 2022, the Fed has raised the short-term interest rate it controls, the target federal funds rate, by 3.75%. This was a significant adjustment after maintaining a near zero percent interest rate policy for two years. The Fed is also trimming its balance sheet of assets in U.S. Treasury and mortgage-backed securities. Both efforts aim to temper inflation by slowing economic growth.

Inflation was mostly a non-issue for decades, but suddenly became a dominant concern for consumers in early 2021. Fed Chairman Jerome Powell stated that “we (the Fed) have the resolve it will take to restore price stability on behalf of American families and businesses.” He notes that price stability is a Fed responsibility and seems to indicate that the Fed recognizes the importance of tamping down the inflation threat. “Without price stability, the economy does not work for anyone,” according to Powell.1

The policy making Federal Open Market Committee (FOMC) started the “tightening” process at its March meeting by raising interest rates and discontinuing asset purchases (known as quantitative easing – more on that below), designed to provide liquidity to the bond markets. The Fed raised interest rates again in May by 0.50%, and followed that up with 0.75% rate hikes in June, July, September and November. It was 28 years since the Fed last raised the fed funds rate as much as 0.75% at one time.2 The Fed also stepped up the pace of trimming back its balance sheet of nearly $9 trillion in bonds it accumulated in recent years.3

What specific actions can investors expect from the Fed going forward and how should investors prepare for the impact of these changes on their own investments?

The role of the Fed

The Federal Reserve acts as the U.S. central bank. Its functions include maintaining an effective payment system and overseeing bank operations. Investors, however, primarily focus on the Fed’s monetary policies.

In setting monetary policy, the Fed attempts to fulfill three mandates:

  • Price stability. The Fed seeks to maintain a stable inflation rate. Its current target is inflation averaging 2% per year over the long term.
  • Maximum sustainable employment. Officially referred to as “maximum employment,” it technically refers to a labor market where the unemployment rate is at a low level. The Fed does not use a specific measure (i.e., unemployment rate, labor force participation rate) to as its goal. Instead, it utilizes a more subjective assessment of the employment environment.
  • Maintain moderate long-term interest rates. The level of interest rates impacts many aspects of economic activity, from consumer mortgages to business financing. Therefore, the Fed seeks to keep rates at modest levels.

The Fed also influences short-term interest rates, specifically, the target fed funds rate, which is the interest rate applied to overnight loans from one financial institution to another. While Chairman Powell receives much of the attention, the FOMC establishes Fed monetary policy. It’s the committee that sets the fed funds rate target and has other authority, including buying and selling of securities.

Rapid rate hikes expected to continue

Although the recent Fed rate hikes appeared to be priced into markets, it remains an open question how many more rate hikes will be needed to get inflation under control. While the fed fund target rate currently stands at 3.75% to 4.00%, expectations were set to raise rates above 4.5% over the coming months. “With the Fed’s recent rate hikes, they’ve moved from a neutral policy stance to meeting the definition of a “tight” monetary policy,” says Rob Haworth, senior investment strategy director, U.S. Bank. He says the market currently anticipates additional rate hikes of 0.50% in December, with additional hikes likely in early 2023.

The intended impact of the rapid change in interest rate policy is to slow the economy, a strategy designed to cool off the surging inflation rate. If successful, it will likely result in weakening the job market as businesses slow activity in the wake of higher borrowing costs. In recent times, unemployment is near historic lows and job openings greatly outpaced the number of available workers. To attract and retain employees, employers boosted wages. “The Fed is clearly going to tolerate higher unemployment to get inflation down,” say Haworth. The result could be reduced consumer demand, which, at least in theory, could lessen the rise in the cost of living.

An end to the era of “quantitative easing”

Another strategy the Fed implemented both during the financial crisis of 2007 to 2009 and once again in 2020 at the start of the COVID-19 pandemic is known as quantitative easing (QE). The Fed purchased longer-term securities on the open market, including U.S. Treasuries and mortgage-backed bonds. These investments in securities (typically in the fixed income market), add liquidity and reduce borrowing costs to encourage economic activity through more lending and investment. This strategy is typically employed when it is no longer possible to make meaningful reductions to the fed funds rate, generally the point when those rates are near 0%.

In March 2020, the Fed implemented an aggressive QE strategy by injecting more than $700 billion in asset purchases. In June 2020, it implemented an ongoing quantitative easing (QE) program to purchase $120 billion of bonds per month – $80 billion in U.S. Treasury securities and $40 billion in mortgage-backed securities.

“Under this program, the Fed became one of the biggest buyers of Treasury securities in the market,” says Tom Hainlin, national investment strategist at U.S. Bank. “They impacted the interest rate environment just by their large presence.” Hainlin notes that with the Fed bumping up demand for bonds, long-term interest rates remained low (high demand for bonds typically helps keep interest rates lower). The program ended earlier this year, and now the Fed is actively trimming its balance sheet.

Since March, the Fed has let existing bond holdings mature, and not replaced those positions, which reduces the size of its balance sheet. As of September, the Fed is cutting back its bond portfolio by about $95 billion per month (only about 1% of its holdings each month) by not purchasing new securities to replace maturing bonds.

The process of the Fed “unwinding” its balance sheet is commonly referred to as quantitative tightening (QT) “This means the Fed is putting less liquidity in the market, requiring other investors to generate demand for bonds,” says Bill Merz, head of capital market research at U.S. Bank. “If inflation remains an issue in combination with the Fed pulling back on its bond holdings, it’s likely to continue to the trend of somewhat higher bond yields.”

Haworth notes that the Fed is moving cautiously in reducing its role in the bond market. “It is a purposefully slow tapering of their balance sheet because they need other buyers to step into the market to take its place. The Fed wants to ensure there’s sufficient liquidity in the system to keep capital flowing and functioning.” Haworth says the Fed’s efforts on this front amount to a “stealth” method of trying to push bond rates higher, but that at the current pace of QT, it will be a long process.

Bond markets respond to Fed tightening

While the Fed’s plan to alter its current asset holdings will most likely affect interest rates on the long end of the yield curve, setting the target fed funds rate directly impacts the short end. Fed rate hikes will likely push yields on short-term securities higher while its reduction of its balance sheet (asset holdings) could result in higher long-term rates. These purposeful strategies have a goal of cooling the rapid rate of growth in living costs. “The Fed is trying to find the delicate balance between stemming the inflation threat without having a significantly negative impact on economic growth,” says Merz.

Interest rates have moved up considerably across the bond market so far in 2022. When interest rates rise, the value of existing bonds in the market declines. The dramatic change in bond yields in 2022 led to a significant setback for most current bondholders. At the same time, those looking to diversify into bonds will benefit from the ability to earn higher yields on those securities.

Inflation remains persistent

Inflation, which had been a fleeting concern for nearly 40 years, became a major concern beginning in the early months of 2021. In that year, the Consumer Price Index (CPI) grew by 7%, the largest calendar-year change in the cost of living since 1981. At the end of June 2022, the 12-month inflation rate jumped to 9.1%. These readings are much higher than recent average annual changes in the CPI.4 Inflation numbers improved modestly since June, but lingered above the 8% level for the 12-month period ending in October. This appeared to keep pressure on the Fed to continue to hike interest rates perhaps farther than many analysts initially expected. Haworth points out that the economic impact of rate changes can take time. “Each rate hike will take six-to-12 months to work its way into the economic engine.” That may be, at least in part, why inflation rates have yet to ease significantly despite the Fed’s drastic policy shift.

“The Fed is trying to find the delicate balance between stemming the inflation threat without having a significantly negative impact on economic growth.”

– Bill Merz, head of capital market research at U.S. Bank Wealth Management

The Fed’s decision to raise rates rapidly over a short period of time may also be designed to send a message to consumers. “If consumers believe inflation is out of control, it could alter their buying behaviors,” says Hainlin. “The Fed is trying to keep consumers expectations anchored by saying ‘we’ll be aggressive now to let you know we have inflation under control.’”

Russia’s invasion of Ukraine and the resulting economic fallout are a complicating factor for the Fed. Among other concerns, Russia is one of the world’s major producers of oil and natural gas, and both Russia and Ukraine are major agricultural producers. Ongoing disruption in commodity supplies due to the military conflict could exacerbate Inflation issues in the short term.

Future inflation data is likely to influence the Fed’s approach to interest rate hikes. Experts attributed the 2021 inflation surge at least in part to factors like supply chain issues. Higher commodity prices are a big contributor to the elevated inflation rate in 2022. The economy slowed in the first three quarters of 2022 compared to the rapid rate of growth it enjoyed in 2021, but higher inflation rates persist. This highlights the challenge facing the Fed as it tries to bring inflation down without derailing the economic recovery.

Will the investment environment change?

In light of the Federal Reserve’s QT strategy and the anticipated fed funds rate increases, investors should prepare for possible impacts.

  • Fixed income market. Interest rates have moved up dramatically in 2022. The yield on the benchmark 10-year U.S. Treasury note reached the 4% level in mid-October. Today’s higher interest rates make fixed income securities more attractive. Investors may consider a focus on high quality investment-grade taxable and municipal bonds. However, if rates continue to rise in the near term, bond prices could decline further. Consider including positions in short-term U.S. government bonds as part of a diversified fixed income portfolio. Short-term bonds are less sensitive to interest rate changes and can help mitigate price sensitivity in a portfolio should interest rates continue to rise.
  • Real assets. This category typically benefits from a persistently elevated inflationary environment. Opportunities to consider center on global infrastructure assets which include utilities, transportation, communications, midstream energy and pipelines.
  • Equity markets. The events of 2022 continue to point to a modest expectations downgrade for equities. Investors may reset earnings expectations if the Fed remains aggressive in its monetary tightening. There are concerns about how higher costs, rising interest rates, less available capital and a potential decline in consumer spending will affect the bottom lines for many corporations.

Be sure to consult with your financial professional to review your current portfolio positioning and if changes might be appropriate given your goals and time horizon.

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