The Fed Turns Aggressive as Inflation Meets Signs of an Economic Slowdown

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It’s the central bankers’ world, and we just live in it. So, as they hiked interest rates sharply, stocks suffered their worst week since the onset of the pandemic, investors staged an exodus from bond funds, and more cracks emerged in cryptocurrencies.

The Federal Reserve raised its key policy interest rate 75 basis points (a basis point is one-hundredth of a percentage point) on Wednesday after The Wall Street Journal presciently reported on Monday that such an increase, the biggest since 1994, was being discussed by the policy-setting Federal Open Market Committee. That marked a reversal from Fed Chairman Jerome Powell’s declaration last month that a 75-basis-point move was not under consideration for the June FOMC meeting.

What changed in those few weeks?

At his news conference following this past week’s confab, Powell admitted that he and the panel were taken aback by the previous Friday’s news of a sharper-than-expected rise in consumer prices for May and the worsening of inflationary expectations in the University of Michigan’s widely watched consumer sentiment survey. By week’s end, however, the worries shifted from demoralizing increases in prices to signs of slowing in the economy, exemplified by reports of weaker-than-expected retail sales and housing starts for May.

The

S&P 500 index
fell 5.79%, its largest one-week drop since the week ended on March 20, 2020, amid the near-meltdown as the pandemic took hold. The

Nasdaq Composite
along with the S&P 500 had its 10th losing week in the past 11, while the

Dow Jones Industrial Average
had its 11th down week in the past 12.

How to Keep Up in a Down Market

Other markets showed distinctly recessionary traits. After shooting higher ahead of the Fed’s telegraphed supersize rate hike, Treasury yields fell sharply as the market pulled back its expectations of future tightening. The two-year note, the coupon maturity most sensitive to Fed moves, rose 11.7 basis points in yield on the week, to 3.164%, but that was off 27.1 basis points from Tuesday’s close. The benchmark 10-year yield was up 8.2 basis points, to 3.238%, but down from the 3.482% recorded on Tuesday by Dow Jones statistics.

In corporate credit markets, meanwhile, investors staged a major exodus from investment-grade and high-yield funds, paralleling the flight from risk in equities.

Oil, at the center of this year’s inflationary upheaval, suddenly was hit with a deflationary downdraft. Nearby crude-oil futures ended the week at $109.56 a barrel, down 9.21% for the week and far below the momentary spike to $130 during the bubble-like conditions in early March. That was reflected in their shares, the market’s heretofore bright spot this year. The

Energy Select Sector SPDR
exchange-traded fund (ticker: XLE) fell 17.16% on the week and ended down 20.36% from its closing peak hit on June 8, which had represented a double from last year’s low.

Oil wasn’t an isolated case, either. Copper, that most economically sensitive commodity, fell 6.6% on the week and was down 18.5% from its early March high.

The effects of the Fed’s monetary policy are becoming apparent elsewhere. Housing already is in a recession, according to Jefferies economists Aneta Markowska and Thomas Simons. Based on monthly data, they estimate that residential investment will contract by 22% in the second quarter, the largest decline since the lockdown, and before that, since the second quarter of 2010. That should knock a full percentage point from the current quarter’s gross domestic product. The Atlanta Fed’s GDPNow tracker puts the current quarter’s growth at precisely nil.

But the real damage may come as a result of the wealth effect running in reverse. The so-called portfolio channel is the main way that monetary policy affects the economy. Joseph Carson, a former chief economist at AllianceBernstein, estimates that households may have lost more in equities and crypto than the $6 trillion total decline in equity wealth from the bursting of the dot-com bubble at the beginning of the century, he writes in an email.

He sees the Fed’s rate hikes topping out at 3%, below the 3.75% to 4% peak discounted by the federal-funds futures market, according to CME FedWatch. The Fed has raised only half that much, to 1.5%-1.75%, but the market has done a lot more, notably by doubling mortgage rates since the start of the year, to over 6%.

In terms of U.S. equities, Wilshire Associates estimates that their value is down $12.5 trillion this year and $13.1 trillion from November’s peak. Carson thinks the effects of the rate hikes already taken and those likely ahead, along with the loss in wealth that he estimates could reach $15 trillion to $20 trillion, would be enough to stop the consumer, the economy, and the Federal Reserve.

Write to Randall W. Forsyth at randall.forsyth@barrons.com