Interest Rates Prognosis: “Restrictive”

interest rates

One of my favorite bits from Seinfeld was a commitment to fake movies. They would build the shows’ plots around their occasional attendance at movie theaters to see these so-called hits. 

There was “Rochelle, Rochelle,” “Sack Lunch,” “Chunnel,” and “Blimp.” But no fake film had as memorable a title as “Prognosis Negative.”

That fake film’s name is reportedly based on the plot of another movie written by producer Larry David. 

The plot: A man receives a negative result on a medical test. However, he doesn’t realize that negative means “good” and spends most of his time thinking that something terrible happened. 

That sounds like Larry David, all right. It also sounds like the prognosis of the economy… Almost.

Interest Rates Prognosis Restrictive

Today, the Federal Reserve released minutes from its May meeting. The Fed said it could move beyond a “neutral” rate setting to address ongoing inflation. Markets anticipate that the central bank will finish the year with the benchmark rate hovering between 2.50% and 2.75%. 

However, the Fed said it would move beyond “neutral”… and take more “restrictive” policy measures should inflation accelerate. The central bank also said it could raise rates now to be more accommodative (read: lower them later) in the future. 

We could see interest rates increase by more than 50 points at one of the upcoming meetings in June or July. Still, even 50-point increases at two more meetings would be unprecedented by the Fed. I’d argue that restrictive policy could help course correct these markets and help us locate a bottom sooner than later. 

There’s too much speculation in this economy. There are still many stocks trading at outrageous multiples. There remains vast misallocation of capital due to inflation and years of low-interest rates. An uptick in rates can be positive for this economy in the long run. Cleansing. 

And the Fed’s willingness to attack inflation and bring us back toward some level of fiscal sanity will benefit us. It will prepare us for the next business cycle, which I expect will look much different from today’s corporate world. 

That business cycle will likely center more on things we need… and less on the things we want. Look for more capital to spill into sectors like food, energy, housing, and transportation, and less around flashy gadgets or trips to space. We need to ground ourselves in reality. The shifts in global economics could bring us into a very challenging future.

What’s Up With the Rally?

While the Fed announced it would move more aggressively on interest rates if it needed, the markets actually rallied into the close. What gives?

Based on my interpretation of the minutes, I feel like the Fed IS concerned about the liquidity issues related to its large balance sheet. Should the Fed start selling parts of its $9 trillion in bonds and mortgage-backed securities, then naturally this could do two things.

First, they are draining capital from the markets since they are selling assets. Second, it could force market participants to stay on the sidelines due to concerns about volatility created in the bond and stock markets. The latter issue is tied to the dramatic impact that the Fed’s tightening had on the market in November and December 2018. 

If the Fed sounds like it might get cold feet… then the markets might think that there’s a chance that it will accommodate interest rates or reduce its tightening schedule.

In fact, the markets have already started pricing in a possible surrender by the central bank. Following the single largest monthly drop in the U.S. money supply in history, the markets have started to price in the possibility that we DON’T get two 50-basis point hikes in a row. This was evident today in the probability of a 25-point hike in July going from 0% to 4.2% on Wednesday. 

Conclusion

I’m not convinced that the Fed can just stop this process cold, as inflation is just too high. The PCE (Personal Consumption Expenditures) reading will arrive on Friday, and based on that report, the markets could scream higher or tank. 

If we are still not at peak inflation, buckle up. If we are passed the worst – which I doubt – then the Fed may allow for a little flexibility.

But not too much flexibility. The Fed’s reputation is on the line, and if a healthy selloff is too much for the central bank to bear, why believe anything they say moving forward. 

The last time that the Fed engaged in the process of rate hikes and tapering this happened: Nine hikes and 12 months of tightening. So far we have two rate hikes… and no tightening. I don’t see how they change course.

Garrett Baldwin
Garrett Baldwin
Garrett Baldwin joined Godesburg Financial Publishing as Chief U.S. Markets Analyst in early 2021. A Johns Hopkins-trained Economist, he’s worked with hedge funds, venture capital firms, angel investors, and economic advisors to the U.S. government. Baldwin specializes in market anomalies and alternative investments. He’s written extensively on momentum, value, insider buying, and other unique strategies that provide investors that elusive edge.
Garrett Baldwin
Garrett Baldwin
Garrett Baldwin joined Godesburg Financial Publishing as Chief U.S. Markets Analyst in early 2021. A Johns Hopkins-trained Economist, he’s worked with hedge funds, venture capital firms, angel investors, and economic advisors to the U.S. government. Baldwin specializes in market anomalies and alternative investments. He’s written extensively on momentum, value, insider buying, and other unique strategies that provide investors that elusive edge.

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