Taking Away the Punch Bowl

William McChesney Martin took the helm of the Federal Reserve in 1951 and didn’t relinquish his role until 1970. He once said that it’s the job of the Fed “to take away the punch bowl just as the party gets going,” that is, hike interest rates when economic growth is strong.

The fed funds rate has been holding near zero since the pandemic began. The reopening, low rates, and fiscal stimulus have fueled the strong expansion. The jobless rate is back below 4% (as of December, U.S. BLS). But inflation is at a 40-year high.

Not only did the Fed keep the punch bowl at last year’s party, but it spiked the punch.

Last year, the Fed came under heavy criticism for failing to react to high inflation. This year, Powell seems set to make up for lost time, laying the groundwork for what could be an aggressive rate-hike cycle. Rates may rise as early as March.

At Powell’s press conference, he no longer stressed the importance of job growth. Instead, he called today’s job market “a historically tight labor market, with record levels of job openings.”

And he fretted there is a risk that “high inflation (might be) more persistent than expected.” He did not rule out a rate hike at each of the seven remaining Fed meetings this year, nor did he dismiss the idea of a ½ percentage-point increase at one meeting.

The Fed hasn’t hiked by ½ percentage point since 2000.

Still, Powell did not offer a roadmap this year, nor did he get into specifics regarding the magnitude of what we might see. A key gauge of sentiment from the CME Group suggests we may see at least five quarter-point rate increases this year.

The table below illustrates the Fed’s more dovish approach in 2021. In the past, the Fed would act preemptively against inflation.

During 2021, the Fed’s focus was on getting people back to work, and rising inflation took a back seat. Today, the unemployment rate is 3.9%, inflation is at 7%, and the fed funds rate is near zero.

The challenge for the Federal Reserve will be to engineer what’s called a “soft landing.” By that, we mean, can the Fed bring down inflation without causing a recession?

Over the last month, volatility has risen as investors have been trying to price in higher interest rates. However, economic growth has been strong. Witness last week’s report by the U.S. BEA that Q4’s GDP expanded by an annual pace of 6.9%. Vigorous growth = strong earnings.

Put another way, the tailwinds caused by the threat of a hawkish Fed have been partially offset by upbeat earnings.