Neither the author, Tim Fries, nor this website, The Tokenist, provides financial advice. Please review our website policy before making any financial decisions.

On Wednesday, the Federal Reserve will meet again to determine the federal funds rate. According to CME Group’s Fed tracker, the most likely rate is another +75 basis point hike, putting the range at 3%-3.25%, down from the current 2.25%-2.5%.

This would be the third consecutive increase of +75 basis points this year. Keep in mind that a rate change of +75 bps is abnormal. The last such increase, before June/July, was in November 1994. Due to this market shock, the S&P 500 fell almost -20% this year, while Bitcoin lost -58% of its value .

The Fed as central market arbiter

It is quite telling that Ethereum (ETH) fell so hard so quickly after the merger. The “sell the news” hype drove ETH up through September 13th to $1,728, only to suffer several price support busts to present $1,347. This is no coincidence, as lackluster CPI data was released at the time.

Risky assets like cryptocurrencies are particularly prone to investor exits during quantitative tightening (QT). Image Credit: Commercial View

The implication couldn’t be clearer. Market momentum appears to be driven primarily by the Fed’s reaction to new inflation data. Indeed, the Fed has worked under a dual mandate of maximum employment and stable prices since 1977. The target inflation rate remains at 2%, as Fed Chairman Powell noted in May, and has repeatedly emphasized since.

“Our goal, of course, is to get inflation down to 2% without the economy going into recession, or, to put it that way, with a labor market that remains fairly strong,”

Jerome Powell interview with Market

The Fed cannot move from this threshold, otherwise it will lose its credibility. While the CPI data landed at 8.3% for August, back into the April range, the Fed is mainly guided by the Personal Consumer Expenditure (PCE) index. For July, the PCE was 6.3%, a change of -0.5% compared to June.

Image credit: Brookings Institution

Meanwhile, eurozone inflation hit 9.1%, the highest since 1999. Along with the euro falling below the dollar, this may sound like a bargain for cheaper US imports, but it is a double-edged sword. A strong dollar can stifle profits from U.S. business sales, further cooling the economy.

Yet this cooling would suppress inflation without aggressive Fed hikes. With the 2% inflation target set, the question then becomes how much will the Fed need to raise rates and over what period? Moreover, with a market so reactive to the increase in the cost of capital, can we maintain a sustainable pace?

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When will the markets receive a reprieve from the Fed?

First, it should be kept in mind that consumer demand is only one side of the inflation equation. The other side is driven by energy expenditure. This is not the responsibility of the Fed but of the international energy market. Although the benchmark Brent Crude Oil has been down for 7 months, it is still up +23% YoY to $91.57 a barrel.

Provided this downward trend continues, then the Fed would have more leeway to suppress consumer demand with interest rate hikes, without inflicting the pain too soon. As Powell has repeatedly noted, increases should also be carefully timed with inflation data. At the current rate, the FOMC has the following inflation forecast:

  • 5.2% inflation by the end of 2022
  • 2.6% inflation by the end of 2023
  • 2.2% inflation by the end of 2024

It is then a question of reacting to macroeconomic variables to achieve this, such as the unemployment rate and real GDP. For 2023 and 2024, unemployment is expected to remain stable at 3.5% and 3.6% respectively. For real GDP growth, the Conference Board recently adjusted its forecasts to 1.4% YoY for 2022, while 2023 is expected to see a further slowdown of 0.3% YoY.

Of course, if GDP goes negative, that results in a recession which is another downward pressure on inflation. On the other hand, in the event of a time lag, the Fed should compensate with aggressive and shocking interest rate hikes.

If this forecast remains on target, the fed funds rate is expected to reach 3.875% by the end of 2023, generating a core PCE inflation rate of 2.9%. Keep in mind that the Fed is primarily focused on core PCE (excluding food and energy) rather than the stock, as food/energy prices are too variable and reactive to supply chains .

Overall, the fed funds rate for this QT cycle is expected to end in 2024, at a rate above 4%. However, during this period there will be plenty of opportunities for a pivot. However, this will depend on factors outside the Fed, related to supply chains and energy costs.

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About the Author

Tim Fries is the co-founder of The Tokenist. He has a B.Sc. in Mechanical Engineering from the University of Michigan and an MBA from the University of Chicago Booth School of Business. Tim was a senior partner on the investment team in the US Private Equity division of RW Baird and is also a co-founder of Protective Technologies Capital, an investment firm specializing in detection, protection and control solutions.