Fed Policy and the Possible Outcomes

There’s plenty of evidence that US markets are all about the Fed right now. When economic and inflation reports come in “hot,” the markets move as traders try to figure the Fed’s next action. When the meeting minutes come out every word is dissected, and the markets react. Finally, when Fed Open Market Committee (FOMC) members speak the markets move. It’s not just lower, either, as we saw recently with the positive reaction to Atlanta Fed president Raphael Bostic’s comments about a potential summer pause in rate hikes.

We see two sides lining up when it comes to where Fed policy is headed. Here is the battle as we see it:

1) The Fed has basically done enough. This side argues that we should see two (or maybe three) additional small (25-basis point) increase this this Spring, and that’s it. Interest rate hikes come with a lag effect, and we are near the time to wait and see what the overall effect of all the Fed’s work will be. The resilience of the economy up to now has demonstrated that it will plow through the inflation fight and come to a soft landing or a mild recession.

2) The Fed has been backed into a corner by the economy’s surprising resilience. Some say the US economy is “defying expectations,” which means the Fed is now forced into additional hikes beyond the recent consensus of 50-75 basis points over the next three meetings (March 22, May 3, and June14). Also, in this scenario the Fed will likely hold rates “higher for longer” to get the desired slowing that many feel is needed to wrestle inflation back toward the 2% target. The result of this path, we feel is a hard landing which will cause significant disruption in equity and bond markets.

We continue to favor scenario #1. While we don’t think the lag time for past rate hikes has been fully accounted for by the markets, it will be by the Fed. Expect inflation to decline enough to allow the Fed to pause after June and evaluate the data. What they will see, we believe, will be economic slowing for sure, but either no recession or a shallow one that allows the economy to muscle its way through this period of high inflation without a huge negative effect on corporate earning and consumer activity.

Remember, the average bear market is about 35% down. No doubt painful! However, the average secular bull market is about 350% up. Historically, those who stay the course have always been heavily rewarded. We feel this is still the case.