Fynsa
At first glance, the statement accompanying the Fed’s decision to raise interest rates by 75 basis points to 2.5% and continue reducing its balance sheet held no major surprises. The move was widely anticipated and already priced in by the market. While the statement’s assessment of economic growth was slightly downgraded, acknowledging that “recent indicators of spending and output have softened,” the assessment of the rest of the economy remained virtually unchanged, and the statement again noted that job gains “have been solid in recent months” and that inflation “remains elevated.”
But things changed at the press conference. Despite openly acknowledging that economic growth is slowing, the Fed unanimously decided to raise rates by 75 basis points—in other words, the focus remains more on inflation than on growth. But the markets began to recover only when Powell noted that “we are now at levels broadly in line with our estimates of neutral interest rates, and after having front-loaded our rate-hike cycle so far, we will rely much more on the data going forward.”
The neutral rate is the prevailing rate at which the economy operates at its potential, without overheating or cooling down excessively. With this 75-basis-point increase, the Fed has just reached its estimate of the neutral rate. From this point on, they are no longer contributing to economic overheating. But that also means that any further increase from here will put the Fed into actively restrictive territory.
At first glance, the Fed’s move makes sense. The trend that has emerged in the bond market in recent months is that inflation will fall—and very quickly. So, if Powell is no longer “on autopilot,” and the markets have a firm view on the collapse of inflation and growth, they can also price all other assets around this baseline scenario. And if you look at market action in recent weeks, it also supports this narrative, with a broad decline in benchmark rates and a more than 10% rally in equities from their mid-June lows.
Thus, it is possible to make sense of the narrative that is taking shape following the FOMC meeting, including the market’s positive reaction to the news that the U.S. economy contracted by 0.9% in 2Q22 (“bad news is good news” for the market) in the preliminary reading—data that, if confirmed, would follow the 1.6% contraction in Q1 2022, meaning the U.S. economy could already be in a “technical recession.”
But let me offer some counterarguments to this market dynamic. The Fed’s move also carries risks if actual inflation does not ease as quickly as expected. Without “forward guidance,” the Fed’s actions could become “highly volatile.” A slight “hawkish” shift, and all the prevailing optimism will vanish.
The market expects the Fed to shift toward easing—perhaps next year—to support the economy if the economic contraction deepens, as it has done time and again over the past two decades. But during those years, inflation was contained and low, and often ran below the committee’s target. Thus, the logic of “bad news is good news” is rooted in the market’s playbook from past recessions, but “the world is different now—inflation is much higher.”
This is the biggest battle against inflation that central bankers have had to wage in more than 30 years, therefore, there can be no realistic and sustainable turnaround for the markets unless real and convincing progress is made on actual inflation. So, for now, “bad news is bad news.”
