The much-anticipated March Federal Reserve meeting concluded last week, and Chairman Powell announced a 25 basis point increase in the Fed’s target funds rate. This was widely expected and is the first increase since 2018. More importantly, Chairman Powell said that the Board was prepared to aggressively address inflation pressure by continuing to raise rates going forward, and to increase future hikes by more than 25 basis points at a time if necessary. He stated that the economy is extremely strong as evidenced by corporate and consumer balance sheets and low unemployment. In sum, the Federal Reserve believes that the U.S. economy can weather the impacts of increased borrowing costs and the resultant slowdown in GDP without slipping into a recession.
I suggested last week that the Fed has a very difficult job in front of it. We have rampant inflation caused by supply chain disruptions and the literal printing and distribution of free money during the COVID-19 pandemic, coupled with a war in eastern Europe and a major disruption in energy and food supplies. Raising interest rates may slow the demand side of the economy and in doing so reduce inflationary pressure, but what is really the cause of the inflation? In my view, the cause is lack of inventory caused by a shutdown of manufacturing in China, where we have outsourced much of everything that we rely on. China largely shut down during the pandemic and is still limited. We have turned over control of our supply chain to a foreign government, and not a particularly friendly one. The same can be said of the current jump in energy prices. We continue to rely on foreign countries for our energy. Unfortunately, these are also countries that are not allies and in the case of Russia, directly adversarial. I am not sure raising interest rates solves this fundamental structural problem, which has been highlighted over the past several years. We are now paying for poor policy decisions that have been made over decades. Interest rates need to normalize, in my opinion, if only to provide ammunition to fight the next financial crisis when it inevitably occurs and to soak up some of the illusory free money that has been spread around. What I am not at all sure of is whether it will have any real impact on the issues at hand beyond making life even more difficult for the average person. It seems to me that this is a precarious dilemma that we find ourselves in.
The initial market reaction has been positive on the equity side with the broad indices jumping for three consecutive days. The S&P 500 has now reclaimed its 200-day moving average and that is a good sign. At the same time, bond yields skyrocketed and are at their highest levels in three years. The obvious takeaway to me is that investors are now adding risk assets to outpace inflation and the corresponding rise in rates, which will likely continue to act as a drag on bonds, treasuries and other perceived “safe assets”. What is not as obvious is that rising interest rates eventually stifle growth and a bear market begins. The Fed is hoping for equilibrium and some resolution to the structural supply/demand issues set out above before that occurs… and so are investors. Time will tell if this is possible.