OMay 4and, the FOMC announced its policy changes. The Fed moved its fed funds target by 50 basis points, the fastest increase in 22 years; the last increase in this amount dates back to May 2000. During the press conference, President Powell ruled out the idea of a rate increase of more than 50 basis points. He did, however, suggest that similar rate hikes of 50 basis points would be likely at least for the next two meetings.
One way to look at the future direction of policy is to compare the level of inflation to unemployment. This is the classic idea of the Phillips curve; although the FOMC apparently abandoned this concept, history suggests that policy has been aligned with this relationship.
The top line of the graph shows the level of fed funds as well as the target; Haver Analytics estimated the policy rate target from 1982. The bottom line shows the spread of the annual change in the headline CPI and the unemployment rate. From the late 1960s to the early 1980s, inflation steadily exceeded the unemployment rate, forcing policymakers to raise the policy rate aggressively to contain inflation. These cycles of tightening have led to four recessions in 12 years. After this experience, the FOMC took steps to raise rates once the gap between inflation and unemployment approached zero. This political position could be described as “pre-emptive”.
However, in the current expansion, the Fed has allowed inflation to significantly outpace the unemployment rate. On the chart above, we have made predictions for the unavailable data for April and May (the yellow shaded area on the chart). We expect inflation to start to decline slowly, but the unemployment rate to remain low. To normalize the rates, the unemployment rate will have to exceed the CPI. The tone of Powell’s press conference suggests that the FOMC is moving toward that goal at a deliberate pace; it is likely that the Fed is hoping inflation will come down as supply constraints ease and therefore wants to give the economy more time to adjust to tighter monetary policy.
The other major announcement was that the Fed will begin to reduce the size of the balance sheet. Quantitative tightening (QT) will begin in earnest in June. The impact of the changes on the balance sheet remains controversial; the expected result of quantitative easing (QE) was a decline in long-term interest rates. Interestingly, QT and QE tended to drive up long-term rates, while a stable balance sheet led to lower interest rates.
On the other hand, QT periods have tended to tighten credit and mortgage spreads. On the chart below, QE periods are in green and QT in beige.
Finally, the relationship between the Fed’s balance sheet and stocks is also controversial.
The S&P 500 often rises during periods of QE and stagnates when the balance sheet stabilizes…until the end of 2016. Stocks rose even with QT, but the positive relationship between the balance sheet and stocks returned during the last period of QE. The model suggests that QT will have a slightly negative effect on stocks. Probably the biggest risk for equities is the economic cycle. Recessions tend to lead to bear markets for stocks. But QT by itself is probably not a bearish event.
So, to recap, tighter monetary policy, which includes higher policy rates and a reduction in the balance sheet, increases the risk of recession. Recessions tend to negatively affect risky assets. We expect credit spreads to widen and equities to weaken if the likelihood of a recession increases. Longer duration yields generally decline, although in periods of high inflation the declines are often simultaneous with the onset of recession. Although we do not expect a recession in 2022, the probability in 2023 is increasing.
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