Friday’s CPI report settled a lot. Inflation is still peaking and the Federal Reserve will have to hike its key interest rate higher and faster than many on Wall Street expected. But today’s Fed meeting policy pronouncements still will answer some key questions that will help determine how long it will take the Dow Jones Industrial Average to find a floor and ultimately start a sustainable rally.
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Quarterly economic projections released along with the 2 p.m. policy statement may yield a couple of answers. Namely, how high do Fed policymakers think rates will have to go and for how long. But Federal Reserve chief Jerome Powell’s post-meeting news conference likely holds the key to the stock market reaction.
After five straight down sessions that have cut 8.5% from the Dow Jones and 10.2% from the S&P 500, could markets be primed for a relief rally? To some extent, the bad news — increased Fed urgency — is good news. That’s because the faster rates rise, the sooner the economy will slow enough to curb inflation pressures.
However, there’s high risk that any rally, just like the one after the Fed meeting in May, will be short-lived.
Super-Sized Federal Reserve Rate Hike
As of Monday, financial markets were still pricing in nearly 70% odds of a half-point rate hike, according to CME Group’s FedWatch page.
The decision was expected to come down to which of two goals the Fed prioritizes. Policymakers want to raise rates as fast as they can reasonably do so to choke off inflation pressures. However, when markets are sliding, the Fed generally tries to avoid giving them an added push on the downside. A surprise 75-basis-point hike might have done just that.
However, the Fed may have gotten around the surprise factor by leaking to the Wall Street Journal that 75 basis points is definitely on the table. That prompted Goldman Sachs and other investment firms to predict a super-sized rate hike. Now markets see a 75-basis-point move as a sure thing.
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The Fed’s urgency was surely heightened by the CPI report, which showed headline inflation hitting a 40-year-high of 8.6%. Surging food and energy prices are part of the reason. But Fed officials may be particularly troubled by prices for nonenergy services rising 5.2%, the fastest pace in 30 years. That includes big spending categories like rent and health care.
As a result of this extended bout of inflation, the University of Michigan’s June survey showed that consumer expectations of future inflation are clearly beginning to rise. Since psychology plays a big part in inflation dynamics, rising inflation expectations add pressure on the Fed to act forcefully.
How Restrictive Will Rates Get?
At his May 4 news conference following the most recent Federal Reserve meeting, Powell hedged when asked whether rates would have to rise to restrictive levels. “It’s certainly possible,” he said, but added that “We can’t know that today.”
While there’s no precise level at which rates will become restrictive, policymakers figure the long-term neutral interest rate is about 2.4%-2.5%.
The last set of economic projections issued in March showed the Fed’s key overnight interbank lending rate topping out at 2.8% in 2023, mildly restrictive.
New projections are certain to show rates moving into more restrictive territory. The FedWatch page now shows the benchmark federal funds target range rising to a range of 3.75%-4% by February. That’s a full percentage point higher than markets were expecting just a month ago.
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Have markets priced in too much tightening? We’ll get an idea from the new set of rate-hike projections. Fed policymakers may not be the best forecasters, but lately they seem to be more candid about what it will take to quell inflation.
Subsequent to the May 4 meeting, Powell adopted a new tone, warning that “pain” might not be avoidable. In keeping with his recent candor, Powell has said that the unemployment rate may go up a few ticks.
The last round of Fed projections in March essentially had the jobless rate stabilizing near 3.5% through 2022, 2023 and 2024. New projections this week probably won’t be quite so ideal.
How Long Will Rates Stay Restrictive?
Aneta Markowska, chief financial economist at Jefferies, sees the current inflation outbreak as reminiscent of the late 1960s. In both periods, an extremely tight labor market and high prices reinforced one another.
In the earlier episode, she wrote, aggressive Fed tightening pushed the unemployment rate up to 6% from around 3.5%. But the Fed declared victory too early, setting the stage for another decade of wrestling with high inflation.
“When faced with a feedback loop between prices and wages, the Fed has to remain tighter for longer,” Markowska wrote. “We certainly don’t expect the current Fed to make the same mistakes. That’s why we expect the nominal funds rate to reach 4% in this cycle. It is also why we expect it to come down more slowly in the next downturn.”
Fed projections for the rate outlook in 2023 and 2024 may show that tight monetary policy may have legs.
What Will Fed Say About Dow Jones Tumble, Crypto Crash?
Federal Reserve policy works on the economy indirectly, by influencing financial conditions — a combination of market interest rates, asset valuations, credit spreads and the ability of companies to raise capital. If the Fed is urgently working to cool demand, policymakers won’t want household wealth to recoup much of this year’s losses. That implies a fairly low ceiling for any near-term stock rally.
But what about the floor? Despite some “volatile days,” Powell told a May 17 WSJ conference that financial markets are “getting through this pretty well.”
At that point, the Dow Jones Industrial Average was 12.4% off its 52-week high, while the S&P 500 was down 16.4% and the Nasdaq composite 27.4%.
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As of Tuesday’s close, the Dow’s loss had grown to 17.5%, while the S&P 500 had lost 22.1% and the Nasdaq 32.6%.
The big question is whether Powell still thinks markets are doing OK. Might Powell throw the Dow Jones a bone?
Probably the most that investors can hope for is that Powell will say financial conditions have tightened a lot and are getting close to appropriate levels. That light at the end of the tunnel might be enough to spark a rally.
Yet Powell may stress that financial conditions will need to remain tighter for some time to come.
After Russia’s invasion of Ukraine, Powell provided assurance that the Fed would contribute to stability, not detract from it. However, Powell’s underlying message has been that getting inflation under control will provide that stability.
Bottom line: Don’t get carried away; it’s a long tunnel.
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Source: https://www.investors.com/news/economy/federal-reserve-meeting-preview-4-key-questions-will-shape-dow-jones-outlook/?src=A00220&yptr=yahoo