Schwab Market Perspective: No Stopping the Fed

Higher rates don't affect the U.S. economy only—the pain spreads around the globe as other countries' currencies weaken against the U.S. dollar. The Fed's aggressive rate hikes have already made markets more volatile, and investors are concerned the U.S. central bank could lead the global economy into recession. However, market volatility on its own is unlikely to deter the Fed. Signs of global financial instability could lead the central bank to enact smaller rate increases in the months ahead, but we don't see the campaign halting before early next year.

Meanwhile, this month's announcement by OPEC+ members that they will curb oil production may not have as big an impact on oil prices and global inflation as some investors fear, for reasons we explain below. However, oil prices could still face pressure from sanctions against Russia as a result of its war in Ukraine.

Such gains make it unlikely the Fed will back off its rate-hiking campaign anytime soon. Bank officials are concerned the tight labor market could drive inflation expectations, which can become a self-fulfilling prophecy.

Workers appear confident they can quit a job and easily find another one. As shown in the chart below, job leavers now account for nearly 16% of total unemployed individuals, the greatest share since April 1990.

Resilient corporate profit margins are another potentially concerning sign, at least to anyone looking for the Fed to ease up. As shown in the chart below, nonfinancial profit margins are hovering near a historically strong 16%, as measured by the Bureau of Economic Analysis (which surveys a broader swath of companies than in the S&P 500).

If the aggressive rise in interest rates helps drive down energy prices, we might expect the headline profitability numbers to fall.

Another headwind for companies' bottom lines is the U.S. dollar's persistent, strong rally this year. As shown in the chart below, the dollar has surged by more than 20% over the past year, the fastest annual gain since 2015 and, before that, the 2008-2009 global financial crisis.

The strong dollar will probably hit earnings eventually. Foreign exchange difficulties often take a while to fully translate into weaker profits. That means companies could be looking at a difficult start to next year.

The Fed is often referred to as the "central bank to the world" because its policies have a big influence on the global economy. Because the dollar is the world's reserve currency, U.S. interest rate changes ripple across the globe in the form of currency volatility.

Between its rate increases and the reduction of its bond holdings, the Fed's recent moves have sent the dollar to all-time highs versus the currencies of the United States' trading partners. A strong dollar helps the United States combat inflation by making imports more affordable—but it makes goods more expensive for the country's trading partners.

To a large extent, the rate of change in the Fed's policy is contributing to the volatility in markets. As noted, the Fed has ratcheted up the federal funds rate—its base rate—by three percentage points since March. That rapid pace has left markets with little time to adjust and re-set expectations. The Treasury market hasn't been this volatile since March 2020.

However, the impact on global inflation may be far less than some fear for two reasons: OPEC production changes haven't led trends in oil prices and the actual cuts may be far less than those announced.

And demand for oil has been weakening. In fact, the International Energy Agency's September Oil Market Report projected that oil markets would be oversupplied by 1 mbpd in the second half of 2022.

The announced cuts acknowledge that weakening, and may not signal a determined attempt to push up prices in a tight oil market. As a result, the OPEC cuts aren't likely to be a meaningful driver of global inflation or the economy, but could instead serve as a lagging indicator of the slowing demand for oil as the global economy weakens.

Saudi Arabia's energy minister has already said the actual cuts would be around 1.1 mbpd to 1.2 mbpd. These estimates are imprecise, especially because it is unclear how much oil Russia is currently exporting.

Whatever the actual number turns out to be, it's likely to be less than 1% of global oil supply. Again, since oil demand has already shrunk, it is unlikely OPEC+'s plans will add significantly to inflation pressures.

That's not to say there aren't other risks lurking in oil prices. Starting December 5, any buyers of Russian oil using insurance, finance, or shipping provided by companies in Group of Seven countries (G7) or the European Union will be required to abide by a price cap dictated by the G7. By cutting current output, Saudi Arabia may just be reserving some production if Russian oil exports plunge after the G7 price cap goes into effect.