The Federal Reserve’s hesitancy to tackle inflation promptly could ruin the interest rate cycle for much of the next decade, according to US veteran investor Richard De Lisle.
The central bank began raising rates in March when US inflation reached 7.9%; several hikes later, interest rates are currently between 2.25% and 2.5%.
Despite the Fed raising rates by a steep 0.75 basis points at its past two monetary policy meetings, US inflation has continued to climb to a 40-year high of 9.1%.
De Lisle, manager of the VT De Lisle America fund, said the delay in starting to lift rates means central bank has had to hike too high and too quickly, which will have a knock-on effect for many years to come.
“All that is an overreaction,” he said. “They're constantly playing catch up because they used the word ‘transient’ for too long. They did for so long that they became a bit of a laughing stock, and we’re now seeing them in fierce mode.”
Now that the Fed has reacted so aggressively, De Lisle expects interest rates to swing up and down over the next few years as the central bank tries to lower inflation whilst also attempting to prevent a recession.
“A pendulum has been set swinging and it can’t be prevented. We’ll see rates rising and falling over much of the next decade much like we did in the 1970s. It’ll swing from one side to the other and it'll be a disaster,” he warned.
In fact, the Fed’s choppy interest rate cycle might not be successful in stopping either inflation or a recession, with De Lisle stating: “We could hit the jackpot and have both high inflation and a recession at the same time. That's the fear that the markets are discounting really and that dominates everything.
“We’ve got this fragility which means that if something can go wrong, it will and it will cause a lot of trouble when it does. You can have a relatively little thing happen and all hell could break loose.”
BlackRock suggested that it is also bracing for such a scenario in its 2022 mid-year report; it said that the Fed must choose to reduce inflation or save economic growth, as both won’t be able to be saved.
It stated in the report: “[Central banks] are not acknowledging the stark trade-off: crush economic growth or live with inflation.
“We will likely see real economic pain – halting the ongoing restart – before the Fed changes course, and there isn’t enough time for incoming data to stop the Fed in its tracks. We see this resulting in the worst of both worlds: persistent inflation amid short economic cycles.”
BlackRock has reduced exposure to developed market equities for the time being as it anticipates “an increasing risk of the Fed overtightening, growth to stall and earnings estimates to be overly optimistic”.
The European Central Bank raised interest rates for the first time for over a decade in July, trailing behind the Fed and Bank of England in tackling inflation.
However, Thomas Donilon, chairman of the BlackRock Investment Institute, said the eurozone’s central bank could trip up on monetary policy and put too much pressure on growth, much like the Fed.
He said: “The ECB looks on the brink of a potential policy misstep – insisting that growth can hold up to justify higher rates. We think the ECB will realise its mistake sooner than the Fed.”
Although the Fed is in a tight spot, Capital Group fixed income manager Tim Ng suggested that the central bank didn’t have much of a choice but to be fierce in the face of rampant inflation.
“We are seeing a significant deviation from the standard Fed playbook we’ve become accustomed to over the past few cycles,” he said. “And the reason is clear: inflation is far too high.”
Ng forecasts several more hikes at the Fed’s next few meetings leading up to the end of the year, but at a slower rate of 0.25 basis points each.
Estimated Fed hikes by 2023
Source: Capital Group
The Fed may be powering on with their interest rate hikes, but Jacob Manoukian, US head of investment strategy at JP Morgan, said the central bank is nearing the end of its monetary policy tightening.
“We are probably closer to the end of the Fed’s rate hiking cycle than the beginning,” he added.
“The Fed acknowledged this backdrop of slowing growth in their policy statement. And while their primary focus is still on getting inflation back to target, in the press conference they hinted that the worst of the tightening cycle is probably over.”
He was optimistic about the Fed’s outlook – the hikes carried out this year may seem like a steep rise, but rates are now at a neutral point that neither stimulates nor smother economic activity.
Rate hike expectation vs neutral rate
Source: JP Morgan
Now that hikes are entering restrictive territory, Manoukian felt confident that the Fed would deescalate its aggressiveness and raise rates in smaller hikes moving forward.
“This aggressive rate hiking cycle has been the primary reason for the poor performance from both equities and bonds so far this year, so smaller rate hikes should be welcomed by investors,” he added.
Similarly, Madison Faller, global markets strategist at JP Morgan, said the central bank was past the hump and easing the rate of rate rises could be good for the equity market.
She added: “We don’t know whether or not the bottom is in, but there have been enough glimmers of hope on the inflation and Fed tightening front, and so much damage already done to markets, that even a modest change towards better news can mean gains for markets.”