Fed Raises Rates: Echoes of the Past

Federal funds rate increases to 3.75–4.00%

Today, the Federal Open Market Committee (FOMC) announced it has increased interest rates, raising the federal funds rate to 3.75–4.00%. The broader macroeconomic picture has been remarkably stable despite volatility and rising input (commodity) prices, with real gross domestic product (GDP) growth at 2.1% for the second quarter. The drivers of growth have been shifting, with the artificial intelligence (AI) build-out contributing a large share of growth so far this year. However, a slowdown in capital expenditures remains a risk to the overall growth trajectory, which has been supported by this sector.

The labor market has been resilient, with the August U.S. unemployment rate at 4.1%, down from a peak of 4.5% in November of last year, although structural changes in the labor market are underway. Inflation, as measured by the core Personal Consumption Expenditures (core PCE) Price Index, has been higher than the FOMC’s target rate since March 2021. It seemingly bottomed out in April of last year at 2.6%, but the latest reading of 3.3% factored into today’s decision. U.S. wage growth has generally been falling; however, it increased 3.1% year over year in August. The global backdrop will continue to be crucial in central bank decision-making, as heightened competition across capital, goods, and intellectual property is likely here to stay.

This increase in the federal funds rate was well telegraphed and, some may argue, largely driven by the bond market. With yields across the curve at cycle highs, the benchmark U.S. 10-year Treasury yield recently reached 5.0%, and the yield curve has steepened meaningfully. Higher front-end rates will do little to address supply-driven inflation fears, as was the case during the 2022 tightening cycle. That said, the U.S. economy is currently well positioned to absorb higher short-term rates, and the rate hike may lend the FOMC some additional credibility. Changes are underway at the Fed, and the use of market pricing to help guide policy is likely to be welcomed, despite pressures on policymakers to the contrary.

Policy and real economy crosscurrents

Despite recent volatility, commodity markets have been a key driver of broader inflation measures. The U.S. Producer Price Index for finished goods increased to 6.6% year over year in August. While companies retain some pricing power due to tariff refunds, they have at times been forced to pass on higher supply costs to consumers. The “Crack-Spread” (a measure of refiner profitability) recently hit a record $59.95 per barrel and continued to rise despite a collapse in oil prices earlier in the second quarter, demonstrating the very “real” nature of commodity markets. In our view, the deterioration in the U.S. fiscal picture further narrows the path forward for the FOMC.

The recent sharp rise in energy costs is likely to offset progress made in shelter and core goods inflation, at least in the short term. Historically, the Fed has tended to view volatile energy prices and their impact on consumers as a temporary tax with a short time horizon, which helps explain its focus on core inflation. Despite this, U.S. inflation expectations have remained relatively stable, albeit above target, and are not breaking away just yet. These factors are all part of a secular shift in the inflation cycle that markets have been grappling with since 2022. In our view, this challenge is likely to persist, even if the underlying catalysts may evolve over time.

U.S. growth has been supported by the AI theme and build-out, and its effects have permeated financial markets as well as the real economy. In our view, the AI-related impacts are moving through localized bubbles driven by competition across the supply chain, with bond markets now experiencing some degree of crowding within the sector.

Opportunities abound

Looking ahead we expect volatility in government bond yields to increase as the path of yields becomes increasingly data dependent. The level of real yield on offer appears attractive today, particularly in the “belly” of the curve, or the 5- to 10-year segment. Absent a slowdown in economic growth, we believe yields could continue to move higher. Supply-side constraints may continue to support commodity markets, but the growth outlook is likely to become a more dominant driver of commodity sector performance going forward. Encouragingly for risk assets, corporate earnings expectations have remained robust despite the significant repricing of bond yields over the past year.

Against this backdrop, we have maintained a cautious stance toward longer-duration U.S. government bonds. While yields may remain volatile, we believe investors may have opportunities to selectively take advantage of further increases in yields, where appropriate.

The core Personal Consumption Expenditures (core PCE) Price Index is the Fed's preferred measure of underlying inflation. It tracks the prices consumers pay for goods and services while excluding food and energy prices, which tend to be more volatile and can obscure longer-term inflation trends.

Duration is a measurement of the sensitivity of a bond’s price to changes in Treasury yields. A fund’s duration is the weighted average of duration of the bonds in the portfolio. Duration should be interpreted as the approximate change in a bond’s (or fund’s) price for a 100-basis-point change in Treasury yields. Duration is based on historical performance and does not represent future results.

The Producer Price Index (PPI) is an inflation gauge that measures changes in the prices businesses receive for their output. Rising PPI readings can signal increasing cost pressures that may eventually affect consumer prices, corporate margins, and monetary policy. You cannot invest directly in an index.

A yield curve graphical representation of fixed-income security yields (usually U.S. Treasuries) at their respective maturities, starting with the shortest time to maturity and sequentially plotting in a line chart to the longest maturity. A yield curve is based on historical performance and does not represent future results.

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