Here’s the Inevitable Outcome From the Fed’s Monetary Tightening

On Wednesday the Federal Reserve hiked the Fed Funds rate by another 75bps. Stocks initially rallied as the statement that accompanied the announcement was interpreted to be ‘dovish’. However, in the press conference that followed, a hawkish Chairman Powell made statements that were discouraging for investors hoping for a ‘pivot’ in the near future. Equities tanked accordingly late that afternoon.

“It’s premature to discuss pausing. It’s not something that we’re thinking about. That’s really not a conversation to be had now. We have a way to go,” he said.

My long-held view was that there were three possible scenarios as the Federal Reserve began monetary tightening.

The first was the central bank would be able to achieve a ‘soft landing’. However, this is the same gang along with Treasury Secretary and former Fed head Yellen, that maintained inflation was ‘temporary’ and ‘transitionary’ throughout 2021, and waited far too long to act. I always put the chances of this outcome somewhere between slim and none. Given GDP contracted in the first two quarters of this year and a slew of more recent economic readings, I think ‘slim’ has already left town on this possibility.

The second potential scenario was that Powell would raise rates until things got uncomfortable in the market and for politicians. He would then end up blinking before getting inflation under control. However, after four straight 75bps rate hikes in quick succession, it’s getting harder to doubt the Fed Chairman’s determination to slay the inflation dragon even if it means putting the economy into a recession.

Which leads us to our third possibility and the one I always put the most weight on. That is the central bank moves its Fed Funds rate up to a point that it seriously breaks something in the economy and the markets. That is looking more and more like the inevitable outcome from monetary tightening. Yes, inflation levels have not come down much and the jobs markets are still strong. However, both of these economic readings have long lag cycles before they show the impacts of recent rate hikes.

By not allowing enough time for the recent huge move upward in rates to be properly assessed, Powell is putting the central bank in a position that it will trigger a huge amount of damage. It then will be unable to reverse course until the economy is deep in a recession.

Already, rate hikes have tanked the housing market. Now the average interest rate on car loans is 6.3%, the highest rate since 2019. With the just implemented 75bps point hike, rates on auto loans would soon be at their highest levels since the aftermath of the Financial Crisis. This will hit another core growth driver of the economy.

The rise in interest rates has already triggered a 15% gain in the dollar in 2022. This is hitting export growth and profit margins for a wide swath of the American economy. For these reasons, I remain very cautious on the markets despite a nice October for investors. I believe we will at least retest yearly lows if not break through them before the Federal Reserve finally gets to a true ‘pivot’ point. I am positioning my portfolio accordingly.