FED may continue to hike rate in September 2022 before ending its current tighening cycle. 

The rebound in risk assets that we’ve seen in the past month, or so, has led to an easing of financial stress measures in the US. Given that Fed officials, including Chair Powell, have pointed to the need for higher rates to tighten financial conditions, it would seem that things are going in the wrong direction. The Fed might have to talk a tougher story or even hike by more just because financial conditions are too loose. But taking this view ignores the way that financial conditions usually move when the Fed goes through a monetary cycle.

For a start, financial conditions lead the rate cycle. What’s more, this happens whether the Fed is tightening or easing policy. It is arguably more pronounced when the Fed is tightening policy because the bank tends to spend a considerable period of time guiding the market towards the idea of higher rates in the future.

This guidance usually forms a well-worn pattern whereby the Fed uses a number of “code-words” to hint at future policy changes. And even if it does not do this, because it is caught out by surging inflation for instance, financial markets usually move to tighten conditions well in advance of the first rate hike.

In fact, financial conditions started to be tightened from around September last year, a full six months before the first Fed rate hike. And while that might sound a long time, it is actually quite short compared to prior cycles because the Fed – and the market – was caught out by surging inflation. The previous tightening cycle saw nearly 18 months of tightening financial conditions before the Fed hiked for the first time in December 2015.

The first point to make about this leading role taken by financial conditions is that the economic slowdown now is arguably more a function of this 6-month period of tightening financial conditions than the rate hikes that started in March. This is because it takes some time for monetary policy to work, whether this is actual rate hikes, or the tightening of financial conditions that precedes the first hike. Looking ahead, the past five months of rate hikes will start to kick in as a suppressant to growth – and inflation – even if there is some counterbalancing occurring because financial conditions are starting to ease again.

A second point relates to what we said earlier, which is that financial conditions tend to lead rate changes in an easing cycle as well as a tightening cycle. Hence, while the Fed might sound frustrated at times with the markets pricing of rate cuts next year, it won’t be very surprised that financial conditions are starting to ease right now.

For while the market won’t have the same degree of guidance about a future easing cycle compared to a tightening cycle, traders and investors are always looking to the future and will still anticipate a downturn in demand, lower inflation and, eventually, Fed rate cuts.

The Fed could try to fight against this market pressure, perhaps even protesting with more aggressive rate hikes but, in Mr. Steve Barrow, Head of Standard Bank G10 Strateg’s view, once the market has its sights set on the top of the rate hill and onto the rate-cut valley beyond, it does not matter whether this hill is a bit higher than anticipated, because the valley beyond (when rates are eased) will be even deeper.

“While all this describes the monetary cycles that we have seen for some time in the US, we do have to recognise that this one is a bit different because inflation is so much higher. Might this mean that the copybook will be spoiled as financial conditions tighten again and continue to become more onerous through the whole of the rate hike cycle and possibly beyond? It is certainly possible and, in the next few months might actually be the more likely scenario. But, over the long-term financial conditions will ease and there’s not much the Fed can do about it even if it wanted to”, said Mr. Steve Barrow.