Friday's Market Minute: More Rate Hikes Are Warranted

Federal Reserve Chair Jerome Powell’s testimony in front of Congress this week reaffirmed the conclusion of the most recent FOMC policy meeting in that higher interest rates are necessary to ensure inflation expectations remain well-anchored. Equities have been under some pressure since the end of last week in a delayed response to less investor-friendly reactions from the Fed and other global central banks. As a result, the S&P 500 may end up closing the week lower after five weeks of uninterrupted gains. Despite no actual action taken by the Fed to tighten rates, their language continues to suggest inflation needs to be dealt with even if it comes at the expense of economic growth. 

Since past rake hike cycles have seen nominal interest rates above core PCE inflation, one could make a case that monetary conditions are still not all that tight, reflected by a resilient economy and a strong stock market. Real interest rates have only recently achieved a neutral condition as measured by the current overnight target Fed funds rate and the most recent inflation report. The 500 basis points of tightening over the past 14 months have merely brought rates high enough to match core inflation which justifies the reason the FOMC remains firm on resuming rate hikes in July. 

There is no doubt equities have had tremendous positive momentum going back to October of last year, but questions remain as to whether a durable upward trend has been established. The bond market continues to suggest there is a high chance of an economic downturn as the yield curve remains deeply inverted and credit creation slows. Since monetary policy operates with a difficult-to-predict lagged effect, confidence in the sustainability of this new bull market will remain in question. Disregarding expectations of an eventual recession and unanswered questions as to how long the yield curve will remain inverted before the Fed pivots towards an easing policy stance, the economy remains strong as new jobs continue to be additive to overall growth.

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