Surprising no one, the Federal Open Market Committee (FOMC) voted to hike its policy rate by 75 basis points (bps; 100 bps equal 1.00%) to a range of 3.75% to 4.00%. In its policy statement, the FOMC acknowledged that growth is beginning to slow even though job gains have continued to be robust. It also said it will consider the cumulative and lagged effects of rate hikes when setting policy. We interpret its statement to mean that the Federal Reserve (Fed) is laying the groundwork to slow the pace of hikes to 50 bps on December 14, when the FOMC meets next. While it could hike an additional 25 bps during the FOMC’s first meeting of next year on February 1, 2023, it’s increasingly likely that the Fed might try to hold rates at around 4.50% for the holidays and well into 2023.

Markets seemed to like the thought that the Fed isn’t going to just keep hiking until it really hurts the economy. The Fed has already hiked a lot in a short period. Monetary policy, like medicine, takes time to work. Thus far, it looked like the Fed was going to just keep delivering extra doses of rate hikes without accounting for the delayed onset of the effects. As the chart below shows, average three-month inflation doesn’t always immediately fall after a rate hike. In fact, it sometimes rises. We are only seven months into this hiking cycle. Historically, less than half the time has core inflation actually fallen seven months into a hiking cycle. If the Fed insists on seeing positive side effects—that is, inflation falling—before it even considers taking a pause, that is impatient at best and foolhardy at worst.

Pausing doesn’t mean backtracking on hikes. In the past, the Fed has been able to pause at plateaus for the federal funds rate, but it more often than not needed to reverse course after it eventually realized it had gone too far or too fast with rate hikes. The most famous pause was in 2006 after it had hiked rates slowly and steadily from mid-2004 through mid-2006. It was able to pause for 14 months. But that was after a slow and steady pace of hikes as it tried to get in front of inflation. This time, it’s been hiking hurriedly trying to catch up with inflation instead.

Maybe the Fed has picked the sweet spot for the federal funds rate where it can sit back and watch the inflation numbers come down and the growth numbers stabilize without causing a recession. That seems highly unlikely, though. Thankfully, the market has already repriced from the January 2022 high to account for some adverse side effects of the Fed’s medicine of higher rates. A mild recession still seems highly likely, but as long as the Fed lets the extended-release medicine of tighter monetary policy take effect without administering too many more doses, the market can continue to look ahead to a recovery. Like most recoveries, this one will likely have many setbacks, but at least we can go from “one step forward and two steps back” to a recovery with “two steps forward and one step back.”

 

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