What to Make of the Fed’s Summertime Hike

The Fed resumed its rate hikes today, lifting the fed-funds target range by a quarter point to 5.25% – 5.50% after pausing last month. Pretty much the entire financial world had penciled this in already, and markets seemingly yawned, closing the day roughly flat. So naturally, attention has turned to what comes next and whether markets will get the long pause—or even rate cuts—allegedly necessary to sustain recent returns. We think this is misguided.

While headlines might be hung up on the Fed, stocks have seemingly long since moved on. Consider: The Fed started hiking on March 16, 2022. Since then, the S&P 500 is up 7.2% in price terms and 9.6% on a total return basis.^[i] Obviously, this wasn’t a straight shot higher, considering the first few hikes came during a bear market, and that bear market didn’t end until October 12. But stocks have come full circle and then some since tightening began. They are also up bigtime since the Fed upped its rate hikes to 0.75 percentage point in mid-June, rising 21.8% in price terms and 24.1% with dividends.^[ii] Since October’s low, the Fed has now hiked six times, alongside price returns of 27.7% and total returns of 29.4%.^[iii] If continued rate hikes haven’t proven problematic for nearly 10 months now, we think it strains credulity to argue the Fed would need to cut in order to keep the party going.

Another thing, and this may be counterintuitive, but rates actually aren’t high by historical standards. Yes, we have seen all the headlines calling this the highest fed-funds rate in 22 years. But more than anything, this shows how much the 2000s have been biased toward low rates. It is easy—even natural, courtesy of recency bias—for people to anchor to this as normal. Take a longer view, however, and the picture changes. Between 1982 and the end of 2008, just before the Fed’s zero-interest rate policy began, the fed-funds target rate averaged 5.35%.^[iv] That happens to be darned near the midpoint of the current range. Obviously the past 14 years have pulled the average lower, but still, before 2008 we daresay no one would have batted an eye at this.

With that said, we agree this tightening cycle is probably close to done. Not because the Fed is predictable, but because simple logic supports it. Inflation is coming back to normal, as our recent commentary on June’s CPI report detailed. Last year’s inflation drivers have all eased significantly, as we also showed. Market-based indicators project only very modest increases from here. The Fed may still be jawboning about needing more evidence inflation is “durably down,” as Fed head Jerome Powell did at his press conference after Wednesday’s meeting, but translating Fedspeak to specific policy moves is an error. Powell said, point blank, that they are deciding things on a meeting-by-meeting basis.

It is easy to get hung up on rate hikes when they dominate financial headlines. Commentators globally portray Fed decisions as make-or-break for markets and the economy. Rate hikes bad, rate cuts good, don’t fight the Fed. Yet time and again, stocks have proven much more resilient during tightening cycles than expected. To us, this is logical. For one, the Fed tends to hike during good times—hence the old adage about its job being to pull the punch bowl before the party gets going. Two, rate hikes may be a means of tightening, but the Fed can tighten for a long while before money actually gets tight. Usually, it hikes because money has been too loose and policymakers are trying to mop up excess. Similarly, the Fed cuts because policy has been too tight, and these cutting cycles often coincide with bear markets and recessions. The initial rate cuts in 2000 and 2007, for example, didn’t presage good times for stocks—quite the opposite.

We won’t go so far as to say don’t mind the Fed instead of don’t fight the Fed, since the Fed can make big errors and those errors can hurt markets. We aren’t saying this is probable now, but we are mindful of the possibility and watching closely. So rather than give you a bumper-sticker slogan alternative, we will leave you with some slightly wordier parting advice: Keep an eye on monetary policy but don’t be fooled into obsessing over it. Small rate wiggles generally don’t move the needle, good or bad, and because monetary policy hits the economy with a long and variable lag, there is plenty of time to assess conditions and make portfolio adjustments if needed. But in all likelihood, the time for that will be when no one is talking about the Fed or calling its actions dangerous, as that is when an error would truly be a surprise—and surprises move markets most. When all eyes are on the Fed, as now, markets tend to price it and move on.