The initial market reaction to the Fed’s 50 basis point hike in May was a sigh of relief, but it was short-lived — we’re now seeing interest rates hit new highs and equity prices fall.
At the end of the day, the Fed is taking its inflation mandate seriously. Unfortunately, the Fed’s toolkit cannot address supply chain issues at ports or get more oil out of the ground to alleviate inflation pressures. Getting prices under control means slowing demand. Part of that happens through the wealth effect: when people feel wealthy they spend more, and vice versa.
Asset prices, including stocks and real estate, are a major part of the wealth effect. With demand running too hot for goods and services, the Fed is raising interest rates to slow demand. Higher financing costs mean households and businesses will find it more expensive to spend. This approach is in stark contrast to the past few decades when the Fed used the wealth effect to increase demand.
A side effect of the Fed’s current policy is lower asset prices. The previous policy created a virtuous circle of rising asset prices and more spending, to make up for the lower growth trajectory. This worked well when inflation was under control and below the Fed’s target of 2%.
The Fed does not want inflation to spiral higher and out of control now. It has to balance this against the risk of increasing the unemployment rate and a potential recession.
A few times in history, the Fed raised interest rates without inducing a recession. This is the “soft landing” everyone would like to see. These periods when economic expansion went on beyond two years are shown in the red arrows below.
Despite rising rates, asset prices historically went higher during Fed tightening cycles. Equity prices were up in six of the last seven hiking cycles, in the first year and in the second year after the first rate hike. There were volatile periods, of course, which is the rule rather than the exception for equities.
For now, we have a playbook to execute. We will continue to monitor inflation data, commodity prices, and the rising U.S. dollar. At some point, the Fed’s policy will have its intended impact. When this occurs, we believe the Fed will look to bring more support to the economy and thus, asset prices.
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