First, the Fed’s thinking about inflation changed (not “transitory”). Then, Jerome Powell received the call (from President Biden). So by last month’s FOMC meeting, Chair Powell was prepared to outline policy steps to fight inflation. The Fed has two mandates—full employment and price stability. Its primary focus is now inflation, believing it can be tamped down without negative impacts to employment. This pivot is not to be missed. The Fed’s tightening cycle is now underway.
Will rate hikes take place quickly (a fast tightening cycle) or spread out over time (a slow cycle)? Current expectations from Wall Street banks are for the Fed to move quickly, raising interest rates between 1.00% to 1.75% during 2022—that’s between four and seven 0.25% interest rate increases.
What are the implications for markets when the Fed tightens quickly? According to a recent study (orange line, middle section) by Ned Davis Research, on average, stocks struggle for a year after the first hike:
Yet, without a first rate hike even in the books, the market is off as much as -10.5% since January 1. Are markets overreacting, or are they anticipating the coming tightening cycle will be unlike any seen in recent history?
Recent employment numbers continue to signal a red-hot labor market and there is mounting evidence for a wage-price spiral. This kind of economic data will likely reinforce restrictive monetary policy actions consistent with a fast cycle. A handy inflation measure to watch for inflation's ebb—the Fed’s own PCE and CPI monthly inflation data.
A move lower to 0.2% monthly (~2.5% annualized) from 0.55% monthly (~7% annualized) will allow Fed officials to pivot away from restrictive policy. Until the Fed can get in front of inflationary measures, markets will likely remain volatile and stocks may have farther to fall.