The Fed raises rates again

Yesterday the Fed announced yet another rate hike. 

In reality, not only was it a widely expected hike, but also its magnitude, namely 50 basis points, was perfectly in line with expectations. 

Nevertheless, the markets did not react well. 

In fact, the S&P500 index lost 1.3% after the announcement, while the Nasdaq lost 1.6%. 

The excess of optimism

This strange reaction of the markets, as though they had been caught unprepared by news that had instead been widely announced, may have a prior cause. 

In fact, both the S&P500 index and the Nasdaq yesterday merely returned to Monday’s levels. 

The point is that on Tuesday, after the release of better-than-expected US inflation data, they had reacted particularly well, indeed perhaps excessively well. It is enough to say that precisely on Tuesday, the S&P500 opened with an instant +2.5% and the Nasdaq even +3.7%. 

Given that the inflation figure was indeed lower than expected, but still very high (7.1%), it was somewhat surprising to see so much apparent optimism. 

It cannot be ruled out that in a situation where many US economic agents were clamoring for the Fed to stop raising rates, someone after the relatively positive inflation figure hoped for an easing of the central bank’s restrictive monetary policy. 

However, this did not happen yesterday, with the 50 basis point increase in rates turning out to be perfectly in line with predictions prior to the inflation figure. 

Fed: the rate hikes

The Fed began raising rates this year in March, raising them from 0.25% to 0.50% with an initial increase of only 25 basis points. 

The Fed had not raised them since 2018, and indeed had not touched them after reducing them in both 2019 and 2020. 

The goal of the 2022 hikes is to cool inflation, and indeed Tuesday’s figure would seem to confirm that this strategy is finally working. 

But what is most surprising is the sequence of the increases. 

It is enough to recall that between 2015 and 2018, over the course of three years, the Fed raised rates nine times, or an average of three times a year, consistently by only 25 basis points at a time. Overall in those three years it took rates from the initial level of 0.25% to the final level of 2.5%, that is, increasing them precisely tenfold in the space of three years. 

The 2022 sequence was much faster and, above all, much more violent. 

In total there were seven rises in eight months, only the first of which was by 25 basis points. In fact already the second was 50 basis points, followed by four consecutive 75 basis point increases. It is probably for this reason that many US economic agents are calling for a less restrictive monetary policy, as well as the fact that on Tuesday the markets were under the illusion that this might be a realistic prospect. 

The fact that the increase announced yesterday was not 75 basis points, like the previous four, but “only” 50, was not able to confirm the unwarranted optimism spread on Tuesday. 

To give an idea of how violent the 2022 rate hike was, one only has to compare it with that of 2018. 

Then with four 25-point increases, rates went from 1.5% to 2.5%, which is less than a twofold increase. 

This year with seven increases they went from 0.25% to 4.50%, or an eighteenfold increase. 

Market fears

But this is not the end of the story. 

Markets fear further increases in 2023, albeit smaller than the average increase in 2022. 

The fact is that, according to the Summary of Economic Projections released by the Fed yesterday, it appears that in September no one within the Fed realistically imagined that rates in 2023 could exceed 5%, while now they even go so far as to believe that they could go as high as 5.75%. 

Actually, already 5% should be considered a very high figure, but it now seems almost impossible that it might not be exceeded. In fact, it would only take a single other increase of 50 basis points like the one announced yesterday to reach this threshold. 

Moreover, at this point it would still only take one 50-point increase, and three 25-point increases, to reach 5.75%. This is certainly a scenario that scares the markets. 

However, everything depends on inflation, because if the acceleration in the descent registered in November continues, indeed the Fed might even decide to relax its restrictive monetary policy. 

Inflation and the Fed’s rate hike

The peak of US inflation in this historical period was reached in June, then exceeded 9%. 

Over the next three months it began to fall, but basically only returned to pre-peak levels. 

The real descent began only in October, when it marked an encouraging 7.7%, compared with 8.2% in September. However, this means that, compared to the peak, it has fallen 1.4% in four months. 

By contrast, in November it fell in a single month by 0.6 points, which is double the average descent in the previous four months. Should November’s descent mark a real reversal, meaning a shift from a slight decline to a large and rapid decline, the Fed’s monetary policies may in fact become less restrictive. 

It is worth noting that the level of inflation in November 2022 is now in line with that of December 2021, when the rise in interest rates had not yet begun. 

Moreover, by now it no longer seems that the Fed’s real goal is to bring it back to that 2% from which it started at the beginning of 2021, and which is the historical target for many central banks, but probably to 3 % or even 4 %, i.e., to levels below those in the latter part of 2021. 

With this in mind, the next inflation figure for December, which will presumably be released before mid-January, could help a great deal in understanding whether the trend is really one of a sharp decline such as to justify rate increases of less than 50 basis points, or whether instead the sharp drop in November was merely a flash in the pan. 

It must be said, however, that such an aggressively restrictive monetary policy is unlikely to yield results, so it is safe to assume that this is the main cause behind the sharp drop in inflation in November.