The Federal Reserve (Fed) and the money markets seem to agree that it’s time for the Fed to shore up its inflation-fighting credentials. As economic data continued to come in hot over the past few months — showing a tight labor market and inflation not seen for generations — the prospect of accommodation removal in its various forms moved from a distant event to one likely to begin soon. The Fed has signaled it will raise rates at its March meeting; the main question over the past month or so has been whether the first increase would be 25 basis points (bps; 100 bps equal 1.00%) or 50 bps.
The Fed will also need to factor in the potential effects of the war in Ukraine on both the economy and risk asset markets. However, while wavering equity valuations have stayed the Fed’s hand at times in the past, economic conditions are sufficiently different today as to minimize the chance of that happening again, with inflation the primary factor. The inflation backdrop was benign when equity contractions moved the Fed to more dovish stances in early 2016 and late 2018, as the Core Consumer Price Index (CPI) ranged from 1.7% to 2.4% over that period. In fact, the Core CPI didn’t exceed 2.4% in the entire decade preceding the recovery from the pandemic, which makes the recent February 2022 reading of 6.4% even more stunning. In the last hiking cycle, the Fed raised rates because it could, and it had an option to stop in the event of an equity correction. This time around, the Fed will be raising rates because it must, and it would take a disruption sufficient to materially alter the economic outlook to move the Fed off its path. Geopolitical uncertainty may help the Fed decide to start with a 25-bps hike rather than 50 bps, but it shouldn’t affect the Fed’s broad effort to remove accommodation this year. And, in fact, in his testimony before the House and Senate Banking Panels on March 2 and 3, Fed Chair Powell endorsed a 25-bp hike at the March 16 Federal Open Market Committee meeting but left open the possibility of a 50-bp hike at a future meeting.
In anticipation of the upcoming Fed meeting, we have positioned the money market fund portfolios with a higher level of liquidity, as well as increased our allocation to investments in floating-rate securities. We believe these measures will enhance our ability to more immediately capture a high degree of rate increases as the Fed commences its tightening cycle.