Today the Federal Reserve (Fed) raised interest rates by 0.75%, a larger move than at the May Federal Open Market Committee (FOMC) meeting and larger than was widely expected just a few days ago. The rate increase was accompanied by forceful statements about Fed officials’ commitment to lower inflation.

The catalyst for the larger rate hike appears to have been the upside surprise in last week’s inflation report. Prior to that report, Fed officials had been uniformly supportive of a 0.5% hike, which was in line with the guidance Fed Chair Powell provided at the May press conference. Powell’s previous guidance, which admittedly was not strong enough to be included in the official post-meeting statement, appears to have been overwhelmed by a desire to appear vigilant with regard to inflation.

The risks to Fed policy are likely to be more balanced going forward
The abrupt change in the Fed’s plans for this week represents yet another hawkish surprise, extending a string of such surprises that started last fall. It is not clear, however, how much longer the hawkish surprises will continue. Looking forward we expect the risks around Fed policy are likely to become more balanced, perhaps even tilting toward dovish risks as yields reach higher and higher levels. In particular, the foundations of more moderate inflation appear to be building, which may obviate the need for further hawkishness. At the same time, the downshifting growth outlook raises the possibility of a dovish adjustment at some point.

As the Fed attempts to navigate the risks on either side of its policy, it is trying again to provide guidance regarding its plans for further hikes. Today Chair Powell commented on the likelihood of either a 0.50% or 0.75% hike at the July meeting. Chair Powell also spent a considerable amount of time talking about the Fed’s expectations for the level of rates at the end of the year, which is also a form of guidance. Previous attempts at offering guidance have been overwhelmed by events, and it remains unclear whether this latest iteration will be any more effective. Nonetheless, it appears that the Fed will keep trying. The desire to control expectations is understandable. While higher interest rates may ostensibly work toward the Fed’s goal of slowing inflation, it’s less clear that extremely elevated volatility in interest rates is all that helpful.

Moderating inflation would obviate the need for further hawkish surprises
The higher-than-expected print in the Consumer Price Index (CPI) for May was the clear precursor to today’s rate hike. The new peak in headline inflation, combined with a slight reacceleration in core inflation, challenged the Fed’s expectation that inflation would be coming down by this time.

It’s important to note, however, that the most watched measures of inflation, particularly including the CPI, have a substantial backward-looking component. The shelter components of CPI, for example, reflect price changes that happened months ago. The more forward-looking indicators of inflation appear to be consistent with moderation, specifically:

• Goods inflation, which was responsible for as much as half of core inflation in 2021, has moderated so far in 2022. There is scope for goods inflation to fall further, perhaps even for it to turn negative, should retailers offer discounts in order to address building inventories and softening demand.
• Wage inflation has similarly moderated. Average hourly earnings increased at a 3.5% annualized rate in each of the last two monthly employment reports, continuing a downward trend in this series that has been in place since last fall. Should wage inflation remain at these levels—a likely outcome, given the ongoing recovery in the labor supply and some diminution in labor demand—that would in turn relieve some of the pressure on services inflation.
• Finally, while house price and rent increases have remained high in the most recent reports, there are signs of slowing in housing as well. The sharp decline in new-home sales, together with much lower levels of applications for mortgages, suggests that the combination of high prices and elevated mortgage rates will weigh on further price increases.

All of these considerations were likely incorporated into the Fed’s forecast, which is why the changes today were only modest. The Fed increased its forecast for core inflation by just 0.2% in 2022 and 0.1% in 2023, in both cases much smaller increments than the changes made to the forecast in March.

In the beginning of the year the Fed’s hawkish surprises coincided with upward revisions in the inflation outlook. That had a certain logic to it: the Fed forecast that the inflation outlook was worse (higher) than before, and at the same time it acknowledged that higher inflation would require a more hawkish policy. The situation now is a bit different. Today’s hawkish Fed surprise did not coincide with a material revision in the forecast. To the contrary, the inflation outlook may be improving, on the margin, and accordingly the changes to the forecast were only modest. Should this trend continue—and in particular should the inflation data start to decline on a month-over-month basis—it would seem that there would be no more need for hawkish surprises.

The Fed is likely to pay more attention to growth going forward
While the inflation data has been the dominant factor influencing the Fed’s recent actions, it is not the only consideration that is relevant for the Fed. In fact, we expect that the Fed is likely to pay somewhat more attention to the growth side of its mandate in coming months. One reason for a shift toward growth is that demand is likely to continue decelerating. Current-quarter GDP growth is tracking below 1%, according to the Atlanta Federal Reserve, which would be the second quarter in a row of below-trend growth. Other indicators of demand have also moderated. Monthly job growth decelerated somewhat in May, monthly gains in real retail sales have moved materially below last year’s pace, and sentiment surveys have fallen significantly.

All of these likely contributed to the downgrade of growth in the forecast released at today’s meeting. The Fed now expects growth to be only 1.7% in 2022, which is below its own estimates of trend. Importantly, this is a substantial markdown from the forecast the Fed made three months ago, when the Fed expected growth to remain comfortably above trend.

Another reason that we expect the Fed to increasingly shift its attention to growth is that eventually the level of interest rates will start to bite. The impact of higher interest rates on economic activity varies by sector, and also varies according to differences in the economic environment. It’s likely that the current level of interest rates has already impacted the housing market. The most recent data suggests a sharp slowing in both home sales and also home construction, very likely related to the 200-bp rise in mortgage rates since the beginning of the year.

We believe as interest rates continue to increase other sectors will be similarly affected and the impact of higher rates will continue to accumulate across the economy in coming quarters. In our view, it seems that the Fed is still a bit optimistic with regard to its growth outlook, and the risks are certainly that the impact of higher rates drags growth further below trend for this year and next. Below-trend growth will, in turn, get the Fed’s attention, as inflation is unlikely to remain elevated for very long in such an environment.

Conclusion
The 0.75% hike at today’s Fed meeting was another hawkish surprise, making it just the latest in a string of hawkish surprises that started last November. This environment has been exceptionally challenging for fixed-income investors. All aspects of the bond market have been affected: Treasury yields have moved sharply higher at the same time as spreads on mortgages and corporate credit have moved wider.

Going forward we expect the risks around Fed policy to become more balanced. And as the risks around Fed policy become more balanced, so too should the market environment for fixed-income investors. Not only may the rise in Treasury yields abate, but lower volatility could also lead investors to reengage in fixed-income spread sectors, especially given current valuations. We anticipate that such an environment has the potential to be quite different than the one-sided risks that have been realized over the past few months.