The US Federal Reserve is often under pressure to ease or change very tight monetary policies, as investors and the general public prefer “easy earnings” or easy monetary conditions. High and rising interest rates can restrict economic activity, increase the cost of capital, and lead to sell-offs of long-term assets such as growth stocks, long-term bonds, and real estate.
In response to inflation that far exceeded its target rate, the Fed has since March of last year implemented one of the most aggressive and unexpected monetary tightening courses in US history. This led to negative surprises and significant declines in growth stocks (-9%), long-term treasuries (-19%) and US real estate assets (-22%). These declines underscore the need for a deeper study of the Fed’s monetary policy and its impact on financial stability. Financial instability has fueled the debate about whether the Fed is ready to “pause” interest rates or even cut them sooner rather than later. Given lower inflation expectations and weaker growth prospects, investors now believe that the Fed will cut interest rates in the second half of the year. Fed funds futures point to 100bps of interest rate cuts by January 2024. However, during the last FOMC meeting in late March, Fed officials decided to increase interest rates by an additional 25bps. Importantly, Jerome Powell, Chairman of the Federal Reserve, has clearly stated that the task of reducing inflation remains a priority and that interest rates are expected to rise further.
Interest rates are set to remain high for a longer period. We expect an additional 25bp increase in May to bring the final Fed Funds rate to 5.25%. In addition, we do not expect any interest rate cuts until at least 2024, despite ongoing concerns about financial instability.
Two factors support our view as we should bear in mind that the Fed’s official monetary policy framework targets an average inflation rate of 2%.
The Fed reiterated the need to adopt a different approach in applying monetary policy tools whereby interest rate policy will be the main tool to combat high inflation, while balance sheet policy will be adjusted, in a targeted manner, in order to support stressed financial markets. This will allow for a more orderly and sustainable process of adjusting monetary policy.
