If the Fed Pulls This Off, It’s Party Time

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Party like it’s 1994? Rather than 1999, the year made famous by Prince’s purple reign, 1994 is remembered as the time the Federal Reserve actually accomplished the rarest of economic feats—a soft landing, curtailing inflation without crashing into a recession.

The Fed did that by decisively tightening policy, starting with an unexpected 25 basis-point increase in the federal-funds rate. It then imposed a series of sharper-than-expected hikes of 50 basis points, culminating with a 75-basis-point move, doubling the key rate in a little over a year. (A basis point is 1/100th of a percentage point.) That pulled inflation below 3% without a recession, setting the stage for the dot-com-led boom that capped the end of the century.

The economic soft landing wasn’t without bumps, however, including upheavals in the mortgage-backed securities market; the bankruptcy of Orange County, Calif., which bet the wrong way on interest-rate derivatives; and Mexico’s peso crisis, resulting in a U.S. bailout. In this century, however, the Fed has tightened gingerly, raising the funds rate in “measured” steps 17 times in 2004-06; maintaining zero rates until late 2015, long after the end of 2008-09 financial crisis; and now lifting rates from zero and ending massive securities purchases, well after the economy has recovered from the 2020 Covid crisis and with inflation at a four-decade high.

It appeared the Fed was going to continue that pattern, based on the actions and projections at its March 15-16 policy meeting. Its Summary of Economic Projections median year-end 2022 estimate for the key policy rate was 1.9%, with it topping out at 2.8% at the end of 2023 and 2024, slightly over the Fed’s estimate of a 2.4% neutral rate. That gentle snugging was supposed to sharply reduce inflation to the 2% range by the end of 2023, with no rise in unemployment and economic growth chugging along near 2%.

The implausibility of that benign outcome was called out here last week. Subsequently, a parade of Fed speakers allowed that sharper, 50-basis-point rate hikes are possible if the data support them. Wall Street Fed watchers then leapfrogged one another to up their rate forecasts, with Citigroup chief economist Andrew Hollenhorst on Friday predicting 50-basis-point moves in May, June, and July.

The markets responded accordingly, with fed-funds futures on Friday pricing in a 2.50% to 2.75% target range by year end and a mid-2023 peak of 3.00% to 3.25%. Treasury yields leapt 34 basis points for the two- and 10-year notes, with the latter briefly topping 2.50%. Yet the major stock indexes posted their second consecutive weekly gain, led by the Nasdaq Composite. It was up 1.98% in the latest week, for a 10.32% two-week advance, while the

S&P 500
added 1.79%, leaving the benchmark a mere 5.29% below its Jan. 3 record high.

Indeed, the stock market has had “everything but the kitchen sink” thrown at it in the past month, said Friday’s daily missive from Evercore ISI, with the war in Ukraine and the surge in oil prices piled on top of higher interest rates. Instead of 1999, maybe we’re partying like 2007, when Citi’s former CEO famously said he was still dancing as long as the music played.

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Write to Randall W. Forsyth at [email protected]