On Repeat: Fed Raises Rates Another 0.75 Percentage Point

With consumer prices powering higher, the Federal Reserve (Fed) has lifted interest rates another 75 basis points (bps). The Fed’s fifth rate hike of the year puts the U.S. target short-term lending rate at 3.0% to 3.25%, its highest level in 14 years.

And if the historical relationship between the Fed’s target lending rate and inflation holds firm, the Fed still has more work to do.

Global Central Banks in Coordinated Battle

The Fed and other central banks continue to face a formidable task in stifling inflation without triggering a severe global economic downturn. So far, the Fed has been more aggressive than its peers, raising rates 3 percentage points since March.

The battle is more dire in Europe, where a mounting energy crisis is fueling record-high inflation. European inflation soared to a record 9.1% in August, while the U.K. inflation rate, which topped 10% in July, hovers near 40-year highs.

The Bank of England lifted rates by 1.65 percentage points between December and August to 1.75%, with another hike likely this week. The European Central Bank waited until July to start tightening with a 0.50 percentage point rate increase. It quickly followed up with a record-high 0.75 percentage point hike in August, pushing the target lending rate to 1.25%.

How Much Higher Will U.S. Rates Rise?

Single-digit interest rates and low inflation have been the norm for many of today's investors. But stepping back in time reveals how high the Fed’s target lending rate and inflation have climbed. In the 1970s and 1980s, the Fed’s efforts to rein in double-digit inflation rates led to double-digit short-term interest rates.

We believe it’s unlikely that today’s federal funds rate target will approach those levels. Today’s economy has much higher debt leverage, so we expect a sharp economic downturn well before interest rates climb to double digits. And any such downturn likely would force the Fed to reverse course.

Nevertheless, we expect more Fed rate hikes. With the two-year Treasury yield climbing to 4%, the fixed-income market is signaling it expects at least another 0.75 bps in Fed tightening.

Accordingly, the odds of a near-term Fed policy pivot remain low. Furthermore, historical data suggest rates will rise further.

Looking back to 1973, financial markets research firm Bianco Research notes the Fed has never stopped hiking before interest rates surpassed the Consumer Price Index (CPI). Figure 1 highlights this data.

Figure 1 | Fed’s Target Rate Has Exceeded CPI

Inflation Stays Stubborn and Strong

The Fed’s resolve reflects the central bank’s concerns about persistently high inflation. Policymakers have suggested they will continue to tighten U.S. financial conditions to restrain inflation, regardless of the near-term negative effects on the economy.

While some consumer prices, particularly energy, eased recently, others have remained stubbornly high. Lower year-over-year energy prices helped slow the annual headline inflation rate, as measured by the CPI, from 8.5% in July to 8.3% in August. However, year-over-year core inflation jumped from 5.9% to 6.3%—a signal that broad pricing pressures strengthened.

Month to month, headline and core CPI have increased 0.1% and 0.6%, respectively, with breadth across sectors. Prices for food, new vehicles, transportation services, medical services and shelter were notably higher. And despite a 5% drop in the energy component, monthly CPI still advanced in August.

Labor, Housing Markets May Be Key to Inflation’s Path

Labor and housing market data remain among the primary inflation-linked data we closely monitor. In our view, slowdowns in these markets should provide notable inflation relief.

Amid worker shortages, strikes and strong employment, wage pressures remain evident across industries, even as economic data continue to stall. A weak labor force participation rate is largely to blame. Participation in the U.S. labor market sank during the pandemic and still hasn’t recovered, as Figure 2 illustrates.

Figure 2 | Americans Are Not Returning to the Workforce

The combination of labor shortages and higher wages fuels inflation on two fronts: People are more willing to spend, and businesses’ labor costs rise. Labor supply and demand will smooth out at some point, but it’s clearly taking more time than the Fed expected.

Meanwhile, housing and rent costs, which comprise more than 30% of CPI, continue to push inflation higher. Although home prices have moderated recently, they’re still higher on a year-over-year basis. This lagging impact on the inflation rate should apply pressure through at least the end of 2022.

Of course, Fed rate hikes are driving mortgage rates higher. The average 30-year rate recently topped 6%, its highest level since 2008. Over time, rising mortgage rates and falling home price affordability should moderate home costs and provide inflation relief.

Economy Is Likely Headed for Hard Landing

We’ve seen severe market volatility recently, as weak economic data led to market expectations for a quick change in Fed policy. But those expectations faded fast on the Fed’s confirmation that taming inflation remains the central bank’s priority.

With its inflation-fighting credibility on the line, the Fed has no choice but to continue raising short-term rates. Because the economy has already contracted for two consecutive quarters, we believe this situation raises the odds of a hard landing and a Fed policy error.

As the economy decelerates under the Fed’s persistent tightening efforts, we expect inflation to cool down in the coming months. We also believe the decline in core inflation will be more gradual than current market expectations.

Additionally, as we’ve pointed out since last year, even when prices moderate, inflation likely will persist and remain higher than the Fed’s target for some time. We believe shelter costs must peak before inflation meaningfully slows.

High-Quality Bonds Merit Renewed Consideration

Treasury yields, including the benchmark 10-year yield, have soared to multiyear highs. However, we believe the market has largely priced in future rate hikes, suggesting Treasury yields are nearing a peak. As Treasury yields stabilize, we expect volatility among high-quality bonds to moderate, too.

Meanwhile, as economic data weakens, riskier assets, including stocks and credit-sensitive securities, likely will remain volatile. We believe high-quality bonds with less credit risk—and now, offering more attractive yields—may serve as prudent portfolio diversifiers in this volatile environment.