Stocks continue to struggle to provide direction since a higher-than-expected inflation report earlier this week dragged markets into their worst one-day decline since June 2020, with the Dow plummeting more than 1,200 points. While inflation remains stubbornly high, investors are increasingly concerned that the Federal Reserve will plunge the economy into recession as it continues to aggressively raise interest rates.
While most Wall Street pundits still forecast the Federal Reserve to raise interest rates by 75 basis points next week, expectations for a more aggressive 100 basis point hike are slowly rising.
Another glowing inflation report on Tuesday virtually confirmed to markets that the Fed will raise interest rates by 75 basis points or more next week. The consumer price index rose 8.3% year-on-year in August, ahead of the 8.1% increase economists expected. While that figure is still below 8.5% in July and 9.1% in June, core inflation, excluding volatile food and energy prices, has remained high. Core inflation rose 0.6% month-on-month in August, twice as much as economists had forecast and doubling from the 0.3% increase last month.
While markets are still broadly anticipating a 75 basis point rate hike, the risks are now on the upside – with investors completely obliterating the chance of a smaller 50 basis point rate hike after Tuesday’s inflation report. Traders are instead now estimating a 20% chance the Fed will raise interest rates by more than 100 basis points, according to CME Group
Economists at Nomura Securities have changed their forecast for the upcoming Fed meeting, which closes next Wednesday, and now predict the central bank will raise interest rates by 100 basis points, followed by increases of 50 basis points at each of its meetings in November and December. “The August CPI report . . . suggests a range of upside inflation risks are emerging,” the company wrote.
If the central bank raises interest rates by 100 basis points next week, “people would start to get really worried, because this would imply that the Fed is not confident in its own timetable and could indeed tighten too drastically and put the economy in a crisis.” would pour. recession,” predicts Sam Stovall, chief investment strategist for CFRA Research.
The last time the central bank raised interest rates by 100 basis points was more than four decades ago, when Paul Volcker was chairman of the Fed. According to CFRA Research, the Fed raised interest rates seven times by 100 basis points between November 1978 and May 1981 (after Volcker took over). Inflation was 9% in November 1978 and peaked at 14.6% in March 1980, while core inflation was 8.5% and peaked at 13.6% in June 1980.
Markets fell nearly 60% of the time, with the S&P 500 losing an average of 2.4% a month after a 100 basis point rate hike, according to CFRA data. While stocks were still falling (down 1.3% on average) three months after a rate hike of that magnitude, the markets eventually stabilized toward the six-month mark, with the S&P rising 0.1% on average by then.
Volcker was responsible for six of the seven historic 100 basis point rate hikes (the first came under his predecessor, G. William Miller). With a strong focus on curbing inflation by any means necessary, Volcker immediately raised interest rates by 100 basis points four times in 1980, shortly after taking office. Interestingly, the S&P 500 even gained 25% that year, although the Fed’s major rate hikes would eventually catch up with the economy, plunging it into recession from 1981 to 1982.
Before Volcker, then-Fed Chair Arthur Burns was slow to react to rising inflation in the 1970s, zigzagging between raising and lowering interest rates. “The problem is, it never really solved inflation,” Stovall says, adding, “the Fed has no intention of making the same mistakes it did in the 1970s.”
Despite some similarities with the high inflation period of 40 years ago, the economy appears stronger this time around, thanks to a solid labor market and stable consumer spending. It remains to be seen whether the Fed can orchestrate a soft landing or whether its aggressive monetary tightening will eventually plunge the economy into a recession similar to that experienced in the early 1980s during Volcker’s tenure.
The latest economic data from Thursday morning showed the picture still remains very cloudy – with retail sales falling below expectations, weekly unemployment claims falling and the Philadelphia Fed manufacturing survey turning negative. The economy is still holding up for now, mainly thanks to a strong labor market, which should dampen expectations for a larger 100 basis point rate hike next week, experts say.
“The pace of rate hikes through the remainder of 2022 and 2023 will depend on how quickly a cooler economy translates into a cooler labor market,” said Bill Adams, chief economist at Comerica.
“The implication is that if we hit 100 basis points, it would throw the market into a loop and put a lot of pressure on stocks,” Stovall says. “Markets have cleared the Fed to raise 75 basis points — no one is going to say that’s too soon.”