Federal Reserve Focuses Monetary Policy on Fighting Inflation | U.S. Bank (2024)

With markets well prepared for the FOMC’s rate decision, the focus turned to post-meeting comments by Fed Chair Powell. Powell indicated that the next Fed move will be to cut rates, but added “we are prepared to maintain the current target range for the federal funds rate for as long as appropriate.”¹ Nevertheless, Powell also indicated in response to reporters’ questions about the possibility of interest rate hikes this year that such a move is “unlikely.”² This response provided some reassurance to investors who were increasingly concerned the Fed might yet again bump rates higher.

Investors were forced to back off expectations about the potential for rate cuts earlier in the year as the U.S. economy showed continued strength and inflation, while significantly lower than its mid-2022 peak, remained above desired levels. The Fed targets a long-term 2% inflation rate, but most recently, the Consumer Price Index (CPI) is 3.5% for the 12-month period ending in March. At the same time, the so-called “core” inflation rate (excluding the volatile food and energy sectors) rose 3.8% over the same one-year period.³ Another inflation measure, one watched closely by the Fed, is the core personal consumption expenditures (PCE) index. It stood 2.8% higher at the end of March compared to the previous year,⁴ further evidence that the Fed’s 2% target remains elusive.

In the meantime, there are other signs that the economy is expanding more steadily than many predicted, and perhaps beyond the Fed’s expectations. The U.S. economy added 303,000 jobs in March, and there remain approximately 1.32 available workers from every open job in the United States.³ As a result, says Eric Freedman, chief investment officer for U.S. Bank Wealth Management, “The environment indicates the Fed may keep rates up higher for longer, and that rate cuts won’t happen as quickly as we’d like.”

Markets react to Fed policy signals

When the Fed first indicated in late 2023 that 2024 fed fund rate cuts were likely, markets initially priced in the first rate cut for the Fed’s meeting in March 2024. However, as various Fed officials commented in recent months that rate cuts weren’t imminent, markets backtracked. After markets generated a first quarter 2024 gain of more than 10.5%, the S&P 500 retreated more than 4% in April.⁵ At the same time, yields on the benchmark 10-year Treasury bond jumped from 4.20% at the end of March to 4.69% at April’s close, reflecting investors’ rising inflation fears.⁶

Inflation’s stickiness

A primary Fed focus since 2022 has been to temper the rapid rise in the cost of living. Headline inflation, as measured by the Consumer Price Index (CPI), peaked at 9.1% for the 12-month period ending in June 2022, but then began to steadily decline. However, after dropping to as low as 3% in June 2023, inflation remained above that level since.³

“Despite its progress since early 2022, current inflation is still above the Fed’s target rate,” says Freedman. “But we think the Fed will have to start cutting rates before inflation drops to its 2% target.” In fact, the FOMC’s projections indicate its expectations are that inflation will remain above 2% in 2024 and 2025, even as the Fed projects rate cuts over that span.

Reducing the Fed’s balance sheet

The other major development after the May 1 adjournment of the FOMC is that the Fed is slowing the level of balance sheet reduction. Dating back to the financial crisis of 2008, the Fed has routinely purchased bonds to bolster market liquidity. However, starting in March 2022, the Fed started reducing its bond holdings. On May 1, Fed Chair Powell reported the Fed would “slow the pace of decline in our securities holdings.” Rather than reducing Treasury bond holdings by $60 billion per month, Powell said the Fed would reduce holdings by just $25 billion per month beginning June 1.¹ It represents a modest step toward loosening monetary policy. “In terms of the market’s response, such a move probably has less impact than a decision to start lowering the fed funds target rate,” says Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management. The Fed’s balance sheet of asset holdings grew to just under $9 trillion in early 2022. It’s now dropped to less than $7.5 trillion.⁷

The U.S. economy holds its ground

Despite significant Fed monetary tightening, the U.S. economy remains resilient, and it appears that the Fed expects growth to continue. That includes an upgrade to anticipated 2024 economic growth as reflected in Gross Domestic Product (GDP). In December, Fed members projected 2024 GDP growth of 1.4%, but have now raised their projection to 2.1%. First quarter 2024 annualized GDP growth came in slightly lower than expectations, at 1.6%, which isn’t necessarily a warning sign for the economy, with growth still driven by solid consumer spending. “The consumer is still hanging in there,” says Freedman. “However, the environment may be getting a little tougher for lower-income consumers.” That may have been evident given challenging first quarter results for restaurant chains like McDonald’s and Starbucks, which tend to be susceptible to consumer spending pullbacks.⁸

Role of the Fed

Congress’ mandate for the Fed is to maintain price stability (manage inflation); promote maximum sustainable employment (low unemployment); and provide for moderate, long-term interest rates. Fed monetary policy influences the cost of many forms of consumer debt such as mortgages, credit cards and automobile loans. While Chair Powell receives much of the attention, the FOMC establishes Fed monetary policy, setting the fed funds target rate and the buying and selling of securities.

Will the investment environment change?

What do recent economic and market developments mean for investors? Today’s market offers opportunities across equities, fix income and real assets.

• Equity markets. After a strong start in 2024, stocks have encountered more volatility recently with markets focused on Fed interest rate cuts. Haworth says investors should consider putting money to work in equities but should be prepared to experience some choppiness. “Investors who have assets to deploy in the stock market may wish to consider dollar-cost averaging over a period of time (consistently investing over at least a six-month period).” This systematic investment approach has the potential to mitigate risks during volatile market periods, while still positioning assets to meet long-term goals.
• Real assets. Publicly traded real estate continues to trade at discounts to private markets (individual properties), offering investors relative value. Over a longer time horizon, crude oil stocks may offer growth potential.
• Fixed income markets. While higher yields can be earned in short-term debt instruments, it’s important to also consider longer-maturity securities. “You don’t want to invest with just a 30- to 90-day outlook,” says Haworth. “You want to look at what’s going to work more effectively to help you meet your long-term goals.” However, in the current environment, an underweight position in fixed income may be warranted. Given ongoing inflation concerns, it may be appropriate to establish a position in Treasury Inflation Protected Securities (TIPS). Within certain non-taxable portfolios, consider a meaningful investment in non-government agency issued residential mortgage-backed securities while managing total portfolio duration using long-maturity U.S. Treasuries. Within certain tax-aware portfolios, consider extending duration and incorporating a modest allocation to high-yield municipal bonds.

Be sure to consult with your financial professional and review portfolio positioning to determine if changes might be appropriate given your goals, time horizon and feelings toward risk given today’s evolving interest rate environment.

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