When Federal Reserve (Fed) Chair Jerome Powell took the helm of the Fed in 2018, the Fed was close to the end of its rate-hiking cycle that started in December 2015. At the time, he said the Fed would be gradual with hikes. Fast-forward to January 2022, and Chair Powell dropped “gradual” in favor of being “nimble.” Then in the spring of 2022, he said the Fed would move “expeditiously” to bring down inflation.

Can the Fed be nimble and quick in taming inflation? No. The Fed has a lot of power but very little control. That can be a toxic combination. Small adjustments to monetary policy slow demand growth and only gradually affect inflation. Only large changes—like the ones in the late 1970s and early 1980s—have more immediate effects on inflation, and those effects are because the Fed effectively throws the economy into a recession. By “gradually,” we’re talking about over the course of many quarters, not over the course of just a few Fed meetings. That’s the lesson from the history of rate hikes, as the chart shows.

More often than not, inflation continues to rise while the Fed is tightening monetary policy. It takes time for rate hikes to bend the inflation curve. Because of the lag between what the Fed does and how the economy responds, investors shouldn’t look to the Fed for quick inflation relief unless they expect some shock and awe coming from the Fed to trigger a recession. The type of shock and awe required to quickly bring inflation down would be to the tune of 750 basis points (bps; 100 bps equal 1.00%), not 75 bps. The Fed probably isn’t too keen on triggering a deep recession since that would go against its other mandate: full employment. Growth slowing is OK, but an economy shrinking isn’t. Chair Powell has noted how hot the labor market is and how it could use some cooling, but freezing things would be taking it too far.

While the Fed is likely to hike by 75 bps—or possibly even 100 bps—at its end-of-July meeting, it’s even more likely to try to temper expectations about how those hikes might affect inflation, and when. Rate hikes generally tighten financial conditions, increasing the costs of things that need to be financed—like homes and autos—and they only lower the costs of other items after time lags that are unpredictable.

Most often, it’s a recession that really brings inflation lower. This time, quick relief that’s at least in the right direction for inflation comes from lower food and fuel prices, and those come from increased production—all things that are beyond the Fed’s paygrade.

In our view, the Fed needs to play the long game with inflation, and investors need to take the long view, too. Years of market excesses should continue to unwind, and the budding separation between high- and low-quality assets should widen.

 

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