425 Basis Points in Nine Months: The Fastest Hiking Cycle Since Volcker

The Year the Brake Pedal Hit the Floor

At the beginning of 2022 the federal funds rate was at zero where it had been since the March 2020 emergency cuts and the Fed was still buying bonds to stimulate an economy with 7 percent inflation. In December the funds rate was between 4.25 and 4.50 percent. The Fed raised a quarter point in March half a point in May then three quarters of a point in four meetings in a row June July September and November beforeto slow down to half a point in December. That's 425 base points hundredths of a percentage point in nine months. It's the fastest adjustment since Paul Volcker broke the great inflation of the early 1980s and when I first laid out the seven decisions on a timeline the acceleration still surprised me

This entry is at the center of the entire Looking Back series. The stimulus years of 2020 and 2021 created inflation. Everything after 2022 - the bank failures the portfolio dregs the eventual soft landing - stems from what the Fed did in these nine months. Read enough of this series and 2022 will stop feeling like one chapter among many. It starts to look like the hinge on which the rest swings

Why So Fast

The speed was an excuse. As our 2021 entry covers the Fed spent that year calling inflation transitory and continued to stimulate as prices accelerated. At the time it moved the CPI was headed for its peak of 9.1 percent in June 2022 the worst in four decades and the Fed was chasing a problem it had let fester

The urgency was also about inflation expectations a term that simply means what people assume future inflation will be. Once households and businesses start assuming that high inflation is permanent they set wages and prices accordingly and the assumption feeds back. Volcker's lesson which this Fed had clearly internalized was that breaking that psychology early whatever the short-term cost is better than letting it set in. In 2022 the Fed applied that lesson a year late and twice as fast.of speed. I think that delay more than the size of any increase is the real story of the year

What Repricing Everything Looks Like

The federal funds rate anchors the price of every asset in the world and 2022 was a living demonstration. The S&P 500 fell about 19 percent and expensive growth stocks that thrived at zero rates fell much more. The Nasdaq fell about 33 percent. The U.S. bond index had its worst year on record falling about 13 percent breaking the classic 60/40 portfolio astory that has its own entry.Thirty-year mortgage rates went from around 3 percent to more than 7 percent freezing the housing market. Cryptocurrencies the purest zero-rated asset of all completely collapsed

The mechanism behind each row is the same. The price of an asset is a claim on future cash flows discounted to today and the discount rate for everything is based on the risk-free rate. If the anchor rate is raised from 0 to 4 percent all valuations in the world will mechanically fall even before wondering if a recession is coming. 2022 was less a judgment on earnings than a change in the rule used to measure them. Once you see that much of theThat year's carnage stops looking like a story about a particular company and starts looking like arithmetic

The Casualty List Arrives Late

The strange thing about 2022 is what was not broken. Unemployment remained near fifty-year lows throughout the year. The recession that all economists had predicted for 2023 still did not come. Monetary policy is known to work with long and variable delays and the real victims emerged later Silicon Valley Bank in March 2023 killed by the bond losses those same rises created the winter of financing for companies and startups and the slow hemorrhage of commercial real estatethat went on for years. When you read the last entries in this series each disaster has a fuse that was lit in these nine months

I think that delay is the hardest thing to keep in mind while it's happening. The damage is real and it's already locked in.You just can't see where it will emerge yet

A Worked Example: What 425 Basis Points Does to a Mortgage

The table above says that thirty-year mortgage rates went from around 3 percent to over 7 percent. It's easy to nod with that line and it's hard to feel it so let me put a number on it with a rounded illustrative example instead of the actual numbers of any actual borrower

Suppose a household takes out a thirty-year $400,000 fixed-rate mortgage. Lenders spread such a loan evenly over 360 monthly payments using a standard amortization formula one that converts an interest rate and the loan amount into a fixed monthly payment. If we apply that formula at 3 percent on $400,000 the payment would work out to about $1,686 a month. Return torun it at 7 percent same borrower same loan amount same 30-year term and the payment works out to about $2,661 a month

Same house. Same loan size. Subtract the two and the monthly payment increased by about $975 which is 975 times 12 or about $11,700 a year simply because the loan discount rate moved by 425 basis points. Lenders typically use the rule of thumb that housing costs should not exceed about 28 percent of the borrower's gross monthly income. Take that $975 increase andDivide that by 0.28 and a buyer needs about $3,480 more in gross monthly income call it $41,800 more a year to qualify for the exact same loan they could have gotten in January. Nothing about the house changed. Nothing about the buyer's job or credit changed. Only the price of money changed and that alone was enough to drive a large portion of potential buyers out of the market. That's the mortgage freeze thatappears in the table above the arithmetic first and the headline after

The same discount logic sets the price of a bond only it points in the other direction. A bond is a claim on a fixed stream of future coupon payments and increasing the rate at which those payments are discounted reduces the price of the bond today mechanically for exactly the same reason that a higher rate increases what a borrower has to pay each month. It's the same math in two different disguises and that's why the legend above can honestly say that a growth stock a bond fund and a mortgage paymentThey were secretly the same operation in 2022

Case Study: Paul Volcker and the Original Shock Therapy

Volcker is already named twice in this entry so he deserves the fuller story because 2022 only makes sense as a smaller faster echo of what he did first. Jimmy Carter appointed him chairman of the Federal Reserve in August 1979 inflation was already in double digits and Volcker made a bet that most of his predecessors had not been willing to make. Killing inflation was worth one recession. Maybe two

Volcker's Fed changed the way it operated targeting the money supply directly instead of softening the funds rate as the Fed normally did and let interest rates go wherever they took them. The result was extraordinary by any modern standard. The federal funds rate exceeded 19 percent in 1981 and the prime rate that banks charged their best customers reached the low twenty percent range. In 1981One mortgage borrower was looking at rates that make 2022's 7 percent look almost mild by comparison

The cost fell on ordinary workers not on inflation in the abstract. The economy fell into a double recession a short one in 1980 and a longer one from mid-1981 to late 1982 and unemployment rose to about 10.8 percent in late 1982 the highest level since the Great Depression. Homebuilders were angry enough to send Volcker in twos and fours in protest. FarmersThey drove tractors to blockade the Federal Reserve building in Washington. It was according to most people the least popular thing a Federal Reserve chairman had done in decades

It worked on its own terms. Inflation fell from the mid-teens to about 3 percent in a few years and the credibility that Volcker bought the Fed by showing that it could really endure the pain is the same credibility that the 2022 Fed was spending from its own reserves. Every time you read that a central bank needs to protect its inflation credibility this is the event on which credibility was built in the first place. The 2022 cycle was fast by any measure.modern but it started at zero and peaked below 4.5 percent. Volcker started in double digits and continued to go over 19. It was different the same underlying logic a completely different amount of pain absorbed to prove the same point

Where This Breaks: When Rate Hikes Do Not Fix the Problem

The model in this entry the anchor rate increases and every valuation on earth adjusts is clean and also incomplete. I want to argue against my own framework for a minute because the 2022 425 basis points worked as well as a bull cycle and it is not guaranteed to repeat itself

Let's start with what a rate hike actually produces. Loans become more expensive so consumers and businesses spend less which cools demand. That clearly works with inflation caused by excessive demand chasing a normal supply of goods which was a real part of the story from 2021 to 2022. It works much less cleanly with inflation caused by supply disruption. Energy and food prices soared sharply after Russiainvaded Ukraine in February 2022 and no rate increase gets a tanker back in the water faster. The Fed was to a large extent using a demand tool to solve a supply problem and the honest reading is that a significant part of the disinflation that followed came from supply chains recovering on their own schedule not just the funds rate

Second financial stability and price stability can go in opposite directions with 2022-2023 being the clearest recent case. The same increases designed to cool inflation also led to unrealized losses on the balance sheets of banks that had long-duration bonds bought back when rates were near zero. Silicon Valley Bank couldn't survive those losses once depositors realized and its collapse in March 2023 forced the Federal Reserve to expend real energyto calm the banking system at the exact moment it was still fighting inflation. When the rise begins to burst the pipes of the financial system itself a central bank has to choose which fire to fight and that is a real limit on how far or how fast this playbook can go

Third long and variable lags cut both ways. Economists conventionally estimate that it takes between a year and a year and a half for a rate move to fully affect the economy meaning that a Fed that keeps hiking until inflation actually falls is by definition hiking well past the point at which enough has already been done. Overshoot risk is built into the tool. It's not a design flaw that anyone can simply fix

Finally I think it's worth admitting that the soft landing this cycle ultimately produced was not what most models predicted.Conventional intuition said that significantly lower inflation should require significantly higher unemployment an actual recession not just a slowdown. That's not exactly what happened which either means 2022 to 2024 was unusually lucky or it means the textbook model itself needs an update. I don't think anyone fully knows yet and I'd treat anyone who claims to be certain about that question with some suspicion

How I Actually Watch a Hiking Cycle

I am not a Federal Reserve economist and none of this is advice on what to buy. What I can offer is how I personally read a tightening cycle now having gone back and reconstructed this meeting by meeting for this series

The first thing I notice is not the level of the rates but the pace. A quarter-point increase and a three-quarter-point increase say very different things about how worried the committee is even when they ultimately land on the same destination. When the size of the moves accelerates from 25 to 50 to 75 that tells me that the committee thinks it is behind as it clearly did in the spring of 2022. When the size slows from 75 to 50 andthen to 25 that is usually the signal that the committee believes the worst of the problem is behind it often long before it says so directly at a press conference

The second thing I look at is which parts of the market move first. In 2022 the most speculative and longer duration assets cryptocurrencies unprofitable growth stocks and long-term bonds moved before the real economy. That order makes sense once you internalize the discount logic mentioned earlier in this post. The longer-term cash flows are the most sensitive to the discount rate so they adjust their prices first and hardest. In my opinion yesThe foam breaks before the data is published the market has already begun to price in the increases that the Federal Reserve has not yet announced

The third thing and this is where I was wrong the first time I experienced part of a hiking cycle is to respect the gap. I remember watching unemployment remain near historic lows for most of 2022 and half wondering if the entire tightening campaign was going to result in a failure. It was not an insignificant event. It was a lit fuse towards Silicon Valley Bank and towards a winter of venture financing that took another year to fully manifest.Appearing calm during a walk cycle is not evidence that the walks are not working. Often it is just proof that you haven't waited long enough

None of this says what to buy or when and I would be wary of anyone who claims there is a clear rule for that. What it offers me is a way to read the Fed's own actions as information the pace of moves and the order in which markets break rather than waiting for a press conference to explain what already happened weeks before

The Bottom Line

2022 ended a fourteen-year experiment with free money in nine months. The 425 basis points were the price of the temporary error of 2021 paid by everyone who owned zero-valued assets forever and the mortgage math above is the same story on the scale of a household's monthly bill. The price revision was brutal but mostly orderly the anchor of expectations held and as the 2024 entry shows the landing was smooth.smoother than anyone dared to forecast at the time smoother than Volcker's own experience would have predicted was even possible. Not everything will always be so clean. Supply-driven inflation accidents of financial stability and the sheer uncertainty of lag are real limits on how well this playbook will work next time. The lesson to follow is simple and uncomfortable. The level of interest rates is not a background detail it is the operating system of finance and 2022 is whatIt looks like a complete system update