• The biggest unanswered question for financial markets at this point is how the U.S. economy will respond to high inflation and tightening financial conditions
  • Some Fed leaders have expressed an openness to a pause or slowdown in the pace of rate hikes at some point this year, but Chair Powell and others have reiterated a commitment to ensuring that inflation is clearly moving back toward the 2% target
  • Household balance sheets began the current inflation cycle in stronger position thanks to government stimulus and slower spending during peak Covid restrictions, but signs of savings depletion are emerging

The primary question still being pondered by financial markets is how the U.S. economy will respond to high inflation and tighter financial conditions via the efforts of the Federal Reserve and other major central banks. For much of May, risk markets struggled on concerns that both were weighing on forward growth expectations. By May 20, the S&P 500 was down 5.5%, but what was perceived to be “less hawkish” rhetoric from the Fed in the final week of May sparked a rebound in risk assets that sent the S&P 500 back to essentially flat for the month. For fixed income, the price action in Treasuries improved as the month of May progressed. Yields declined amid the broad risk-off trade, but healthier two-way flows emerged and rate volatility subsided. However, it’s still premature to call an end to broad market volatility, particularly heading into typically less-liquid summer months with inflation uncertainty still very much present.

The market is now priced for two 50 basis point rate hikes at the June and July FOMC meetings, as well as a 75% probability of another 50 bps hike at the September meeting. This would bring the fed funds rate very close to the Fed’s current projection of a 2.375% neutral rate, and the market is currently priced for the FOMC to move into restrictive territory with a funds rate of close to 2.75% by year end. However, there has been some talk of a potential pause in rate hikes this year for the Fed to assess the impact of policy tightening on inflation and economic growth. On May 23, Atlanta Fed President Raphael Bostic expressed this sentiment, saying that his “baseline view” is that a pause at the September FOMC meeting “might make sense” following three consecutive 50 bps rate hikes. The minutes of the May 4 FOMC meeting, released just two days later, hinted at a similar thought process…

“Many participants judged that expediting the removal of policy accommodation would leave the Committee well positioned later this year to assess the effects of policy firming and the extent to which economic developments warranted policy adjustments.”

The reference to “expediting” corresponds with Chair Powell’s characterization of front-loading rate hikes to deal with excessive inflation risks in the near term, as well as an expedited announcement of balance sheet reduction. However, this idea of a pause seems to conflict with more hawkish comments by Fed Chair Powell in the weeks prior. On May 12, Powell admitted that the process of getting inflation under control will include “some pain” and acknowledged that soft landing will depend on “factors that we don’t control.” A week later, when asked how high he thinks the Fed will have to raise the fed funds rate to achieve its objectives, Powell suggested the policy rate should reach neutral in the fourth quarter, but that it wouldn’t constitute a “stopping” or “looking around point.” “We don’t know with confidence where neutral is…we don’t know where tight is,” said Powell. “We just don’t, particularly in this environment of higher inflation and very strong growth in a really tight labor market.” For the Fed to change the current pace of tightening, he said they would have to see “clear and convincing evidence that inflation pressures are abating,” and if so, they would consider moving at a slower pace. If not, Powell reiterated an openness to being even more aggressive.

Therefore, while some Fed leaders are expressing an openness to a pause in policy tightening at some point in 2022, Powell has made clear that, from his perspective, doing so will require a clear reversal in current inflation trends. Fed Governor Christopher Waller emphasized this viewpoint as well on May 30. He said he supports 50 bps rate hikes “for several meetings” and wouldn’t support taking such hikes off the table until he sees inflation coming down closer to the 2% target. For the time being, the fixed income market appears appropriately priced for current Fed guidance, and looking forward, the greatest source of uncertainty and, consequently, market volatility is how inflation and growth will respond to tighter financial conditions.

Consumers Relying More on Savings & Credit?

Last month, we highlighted the fact that household balance sheets entered the current inflation cycle in much better condition than in previous cycles, thanks in large part to government stimulus and increased savings amid Covid lockdowns/restrictions. Exhibit 1 tracks household liquid assets using quarterly data from the Fed. This metric includes currency, checking & savings accounts, time deposits, and money market funds, and from the end of 2019 to the end of 2021, these assets grew $4.8 trillion, significantly outpacing the previous average annual growth rate of the post-crisis era. Recent data suggest that consumer spending remains robust, and to maintain the current consumption trend, it appears that consumers are dipping into savings and relying more on available credit. In the April report, personal income was up 0.4% m/m, while spending rose 0.9% m/m (not adjusted for inflation). As a result, the personal savings rate fell 60 bps to 4.4%, the lowest since 2008.

It would appear that consumers are now utilizing savings and credit to fuel consumption habits, particularly with prices higher for virtually all goods and services. The Fed’s measure of revolving credit balances (i.e., credit cards) rose $31.4 billion in March, obliterating the previous record high of $14.6 billion in December 2019.  There can always be some noise in data series like this, but inflation and pent-up travel spending for the summer could explain it as well. The latter doesn’t necessarily mean credit was a necessity, but rather an initial method of payment. Nevertheless, household balance sheets began this cycle with much more buying power, which is effectively exacerbating the Fed’s problems on the inflation front.

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