Financial Conditions Eased After 75-Basis-Point Rate Hike

August 1, 2022

Financial Conditions Eased After 75-Basis-Point Rate Hike Photo

The Federal Reserve (Fed) raised rates by 75 basis points last week. The meeting was widely considered to be dovish, for two main reasons: The Fed indicated that the current federal funds rate is around neutral level and the terminal rate is around 3.5%. The Fed also removed forward guidance and moved to data-dependency, like the European Central Bank did last week. Financial assets rallied sharply and financial conditions reached the easiest level since March. 

Is this really what the Fed wanted to accomplish? Its dovish pivot could look prescient if inflation does come down to 2%-3% over the next six to 12 months. The risk is that inflation proves to be stickier than the Fed had hoped and it needs to turn hawkish again later. My feeling is that the current economy is very different from its pre-pandemic status, and now has a higher equilibrium level for inflation rate. This makes me question how sustainable the recent rally can be.      

Earnings have generally been a boost for the stock market this quarter. Many were bearish on earnings as we walked into this earnings season, and this sentiment has definitely lowered bars. Another factor is that earnings are much more correlated with nominal gross domestic product (GDP) than with real GDP. Even though we had -0.9% annual real GDP growth for Q2, the nominal GDP grew at a 7.8% annual rate in the same quarter. 

Nonfarm payroll statistics for July will be released this week. Since the Fed is data-dependent now, I expect larger-than-usual market reactions to the data release.

Tags: Federal Reserve | Inflation | Interest Rates | Earnings | Markets | GDP

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