US Federal Reserve Raises Interest Rates By 50bp to 0.75-1.00% Target

• Core inflation in the US soared to 5.2 per cent in March, compared with the previous year
• Federal Reserve target inflation rate is 2 percent
• Federal Reserve considers US the US economy is strong enough to withstand higher interest rates  
• Markets braced for Federal Reserve Funds rate of 2.75 percent by December 2022
• Lower US bond yields post rate rise imply further rate rises unlikely to rattle markets

US half-percentage interest rate increase

In a widely anticipated move, the US Federal Reserve Board increased the target range for the Federal Funds interest rate by half a percent to a higher range of 0.75 percent to 1 percent. This is the second consecutive monthly rate rise of half a percent since 2006 and the first time in 20 years that a rate rise of more than a quarter of one percent has been applied in a single Reserve Board policy meeting. 

What the Federal Reserve said

The Federal Reserve Board met over two days so their well-considered commentary has been carefully analysed by global debt markets and banking institutions. The Federal Reserve statement released after the meeting observed that the war on Ukraine has pushed up energy and commodity prices, creating upward pressure on the rate of inflation. The Federal Reserve also noted that further recent COVID-19 related lockdowns in China are likely to exacerbate current supply chain bottlenecks. These disruptions are adding to input costs and weighing down on economic activity. The looming inflation problem is further compounded by the existing tight labour market in the US at 3.6 percent unemployment and an increase in employment numbers in March of 431,000.  This is among the tightest labour market in US history and is a sure sign of price pressures becoming more entrenched as wages are a major component of input costs, leading to higher inflation, especially during periods of high consumer demand, when the economy is strong.

The Federal Reserve’s preferred measure of core inflation is the personal consumption expenditures price index, and this soared to 5.2 per cent in March, compared with the previous year. This is well outside the Federal Reserve’s stated inflation target of 2 per cent and implies that there are more rate rises on the way. The question for markets now is how many interest rate rises are on the way.    

The Federal Reserve chairman, Jerome Powell, assuaged bond and equity market fears that the recent rate rise would be higher at 0.75 percent and not 0.5 percent. The markets feared that a 0.75 percent increase may tip the global economy into recession. Chairman Powell sated that further rate increases are planned for the coming months ahead; however, he stated that the increases will be in increments of 0.5 percent. He added that moving more aggressively on interest rates was not under active consideration. 

This implies that the Federal Reserve is targeting a neutral Federal Funds rate, which is widely considered to be somewhere between 2 and 3 per cent, although some economists consider it may be much higher, especially now that inflation has well overshot the Federal Reserve’s two per cent inflation target. Powell said a neutral rate was “not something we can identify with any precision” and stated the Federal Reserve “will not hesitate” to go beyond that threshold if warranted by the data.

Assuming two consecutive Federal Reserve rate rises in June and July, each of half a percent, the Federal Reserve interest rate would rise to be 2 percent. To achieve a neutral funds rate of (say) 2.75 percent, will require at least three rate rises of a quarter of one percent in the months of September, November and December. 

The market response

Chairman Powell’s forward guidance was well received by capital markets when he indicated a less aggressive stance on interest rates to what was previously anticipated by global capital market participants.

The US bond market reacted favourably to this reassurance, by immediately lowering the 10-year and 30-year bond yields by 0.037 percent and 0.027 percent to 2.96 percent and 3.037 percent. Equity markets also responded favourably with the Dow Jones Industrial Average finishing up 932.27 points, or 2.8%, to 34061.06. The S&P 500 jumped 124.69 points, or 3%, to 4300.17. Both indexes had been down earlier in the day.

 Markets are now braced for a 0.5 percent rate increase at the next two Federal Reserve Board interest rate policy meetings in June and July. The Capital markets understand that the pandemic-era stimulus does not sit logically with the existing tight labour market in the US at 3.6 percent unemployment. Accordingly, markets anticipate increases of a quarter of 1 percent in September, November and December, taking the Federal Funds rate to 2.75 per cent by the end of the year. Federal Reserve officials believe the US economy is strong enough to withstand this tighter monetary policy stance. 

This commentary from the Federal Reserve Board has clearly calmed markets for now and with further rate increases baked in to bond and equity prices, markets are unlikely to sell-off when the increases are announced. 

This Post Market Wrap is presented by Kodari Securities, written by Michael Kodari, CEO at KOSEC.