Tom Wald, CFA®, Chief Investment Officer, Transamerica Asset Management, Inc.
The Federal Reserve currently faces a predicament that few of its predecessor committees have ever experienced. Inflation is hitting the economy, businesses, and everyday people like a rock thrown at full force. As the Fed seeks to mitigate this rise in consumer prices, the highest in more than 40 years, it is also attempting to engineer a soft landing for the economy off the red-hot pace of growth experienced since the depths of the COVID-19 collapse two years ago.
One might say it’s a bit like walking a tightrope. Or, perhaps more accurately, like walking a tightrope while someone throws a rock at you.
Looking Down Long-Term Memory Lane
Perhaps the best precedent Federal Reserve Chair Jay Powell and his colleagues could refer to would be the Paul Volcker-led Fed of the early 1980s. Facing runaway inflation into the teens and with a federal funds rate of equivalent magnitude, the Fed took that rate to 20% in May of 1981 to slow the pace of stratospheric consumer price increases.
However, in that case, the choice between double-digit inflation and recession was made early and easily. Fed Chairman Volcker chose to dodge the rock and ignore the tightrope. Within a year and a half, inflation had been cut by more than two-thirds to less than 4%, but not before the country had experienced a full-fledged recession lasting into the final months of 1982. That was the price Chairman Volcker was willing to pay, and history now solidly supports it to have been the right decision.
The recession of July 1981 through November 1982 was a painful one as unemployment surpassed 10% and gross domestic product (GDP) fell peak to trough by -2.7%. Yet by its completion, the economy was primed for eight years of expansion and inflation would go on to average less than 3% over the next four decades. Driven by rising economic growth, declining interest rates, and lower inflation, the strongest bull market of a generation soon took flight even before that recession officially ended. As a result, anyone who invested in the S&P 500® on the day of that peak Fed rate hike in May 1981 would have more than 90 times that amount today.
Paul Volcker, who passed away in 2019, now holds a place in economic history viewed by most as nothing less than heroic and perhaps deserving of enshrinement into the tough decisions Hall of Fame.
Comparisons to Today
It is important to note that while the economic conditions of the early 1980s may be the best precedent Chair Powell and his fellow Fed members have, it is far from a perfect one. In fact, it probably ranks as a decent comparison but not much more than that. Nonetheless, it may be the only history they have to go on.
At this juncture, all signs point to a choice by Chair Powell and his colleagues to continue walking the tightrope. Given that the starting point for the federal funds rate was zero at the point of last year’s inflationary surge (as opposed to double digits for Chairman Volcker), this may still prove to be a good decision. Yet time is not on the Fed’s side. Should inflation continue to rise at current rates or further accelerate into the latter half of the year, this Fed may find itself in a Volcker-like predicament where walking the tightrope will no longer be an option. In this regard, the next several months or so will prove crucial.
The Here and Now
As expected, on May 4 the Federal Reserve raised the target range of the federal funds rate by 0.50% to 0.75%–1.00% in its largest single-meeting rate hike in more than 20 years. As further rate hikes await the economy and the markets in the months ahead, we believe the following points are important for investors:
Along with the rate hike, the Fed also provided official guidance on expected balance sheet reduction.Amid heavy anticipation as to how much and how fast it would be reducing its $9 trillion of Treasury bonds and mortgage-backed securities, the Fed announced plans for this activity at a pace of $47.5 billion per month beginning in June and working up to $95 billion by August ($1.1 trillion annually). While this was in line with previous guidance from Fed officials, the formal announcement highlighted the direct impact of Fed policy on longer-term bond yields.
Following the Fed’s official statement, Chair Powell’s guidance appeared to leave the markets somewhat confused. Prior to the meeting, market expectations, as determined by federal funds futures trading, implied a 0.75% increase to the federal funds target range at the upcoming June meeting. However, during the post-meeting press conference, Chair Powell stated, “A 75 basis point increase is not something that the committee is actively considering.” Markets then immediately rallied strong to close the day, only to give it all up and then some in the following day’s fierce sell-off, as federal funds trading reversed back to a 0.75% expected rate hike in June.
As recession fears mount, the Fed is walking a tightrope between inflation and slowing economic growth. Following the Bureau of Economic Analysis’ advance estimate of negative 1Q GDP growth, the Fed must now navigate a path seeking to mitigate inflation and avoid recession. Given the difficult choice it’s hoping it will not have to make, we believe the markets would rather the Fed lean harder toward preventing higher rates of inflation, hence the negative reaction to Chair Powell’s comments.
In the days following the Fed’s meeting, the Bureau of Labor Statistics released the April nonfarm payrolls report displaying 428,000 new jobs added to the economy. With an unemployment rate 3.6% and year-over-year average hourly wage gains of 5.5%, this report fueled further inflationary concerns and questions as to whether the Fed is still behind the curve on fighting inflation.
We believe given further inflationary pressures, the Fed will be raising rates at each of the remaining five meetings between now and the end of December, in our judgment likely closing out the year with a lower bound on the federal funds target range of 3.00%. We also believe given this pace of rate hikes combined with that of a balance sheet reduction, a realistic year-end target on the 10-year U.S. Treasury yield is 3.50%.
At the current time it appears Chair Powell and his fellow members may still seek a methodical path to higher rates based on the premise inflation will soon react accordingly and inversely. While this may still prove to be the case, in the event it does not, the tightrope may no longer prove to be an option.
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