Last week at the Federal Reserve, the Federal Open Market Committee (FOMC) launched the next interest rate cycle, voting to move the Fed Funds target rate up to one quarter-point to 0.25-0.50% in response to the stubborn level of inflation. The Summary of Economic Projections, or so-called “dot plot,” suggests additional rate hikes at each of the remaining six meetings this year, with some Fed officials calling for a more aggressive path to higher interest rates.
With core inflation (the Consumer Product Index, or CPI) running at 6.4%, headline CPI at 7.9% and, unemployment at a low of 3.8%, many observers are questioning whether the Fed is “behind the curve”, late to adjust monetary policy. Per the Fed, since 1977 the officials have operated under a mandate from Congress to “promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” The employment and price goals are commonly referred to as the Fed’s “dual mandate.”
Since the early 1980s – the last significant rise in inflation and interest rate surge – the average rate of unemployment at the start of a cycle of Fed rate hikes was 6.3%, while the average core CPI rate was 2.7%. We’re far from these averages now for both metrics. Moreover, the Fed Funds target rate averaged 4.4% at the beginning of the previous rate-hiking cycles over the last 40 years.
If the Fed is late in raising rates, it could force a shift to a more aggressive path of tightening, which would include rate hikes and potentially a contraction of the Fed’s balance sheet. The Fed Funds futures curve embeds this scenario as likely; market participants currently give a 76% chance that the median of the dot plot is too low. The curve also embeds rate cuts in 2024, suggesting the Fed will make a policy error during this cycle and be forced to lower rates.
This has meaningful implications for equity markets and raises the potential for a bear market. The S&P 500® Index experienced a correction earlier this year with a drawdown of 13%. Corrections of 10% are not uncommon or unhealthy, as they occur once or twice a year on average, but a bear market (a decline of 20% from a recent peak) is rare without a recession.