Fed Funds at 5.5%: The End of the Hiking Cycle?

Khan Capital | July 2023

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Key Takeaways

• The Fed raised rates to 5.25-5.50%, the highest level in 22 years, completing a 525-basis-point tightening cycle over 16 months, the most aggressive since the Volcker era.
• Headline CPI had fallen from 9.1% to 3.2% and core PCE from 5.6% to 4.1%, but services inflation remained sticky, and the journey from 4% to 2% was expected to be slower and harder than the initial descent.
• The gap between the final hike and the first cut would ultimately prove to be 14 months, as the Fed maintained the “higher for longer” stance while waiting for sufficient evidence that inflation was sustainably declining.
• Cash yields above 5% created the most attractive risk-free returns in 15 years, fundamentally altering the opportunity cost calculus for equity investment and reducing the urgency to take duration risk.
• The neutral rate debate, not the terminal rate, is the key variable for the medium-term outlook: whether neutral is 2.5% or 3.5% determines the magnitude of the eventual easing cycle and its impact on asset valuations.

On 26 July 2023, the Federal Reserve raised the federal funds rate by 25 basis points to 5.25-5.50%, the highest level in 22 years. It was the eleventh hike of the tightening cycle that began in March 2022, bringing the cumulative increase to 525 basis points in just 16 months. Chair Powell’s post-meeting remarks were deliberately noncommittal: the decision on further hikes would be “data-dependent,” made “meeting by meeting.” He neither declared victory on inflation nor ruled out additional increases.

The market’s interpretation was less ambiguous: this was likely the final hike. Fed funds futures immediately priced a probability below 25% for any additional increase in 2023. The attention shifted from “how high” to “how long,” the question of how many months the Fed would maintain rates at 5.25-5.50% before beginning to cut. The answer, as it turned out, would be 14 months, a period during which the economy would prove far more resilient than the consensus expected, the recession that was widely forecast would fail to materialise, and the inflation picture would improve gradually but incompletely.

The Tightening Cycle in Retrospect

The journey from 0-0.25% to 5.25-5.50% in 16 months was the most aggressive tightening campaign since Paul Volcker’s inflation-fighting crusade of the early 1980s. The cycle included four consecutive 75-basis-point hikes (June through November 2022), a pace not seen since 1994. It was interrupted by the March 2023 banking crisis (the collapses of SVB, Signature, and Silvergate), which paused the hiking cycle for one meeting before the Fed resumed with a 25-basis-point increase in May.

The cumulative impact of 525 basis points of tightening, combined with the reduction of the Fed’s balance sheet from a peak of $8.9 trillion toward $7.7 trillion, represented the most comprehensive withdrawal of monetary accommodation in the post-war era. Every sector of the economy was affected: mortgage rates doubled, business borrowing costs surged, consumer credit tightened, and the cost of capital for the speculative assets that had thrived in the zero-rate era (crypto, meme stocks, SPACs, unprofitable tech) was restored to levels that exposed the fragility of business models built on free money.

The Inflation Picture: Progress but Not Victory

By July 2023, headline CPI had fallen from its June 2022 peak of 9.1% to 3.2%. Core PCE, the Fed’s preferred measure, had declined from 5.6% to approximately 4.1%. The progress was genuine but heavily concentrated in goods prices (which had normalised as supply chains recovered) rather than services prices (which remained elevated due to sticky shelter inflation and wage growth). The disinflationary progress from supply-side normalisation was largely a one-off gift; the remaining journey from 4% to 2% would require the harder work of demand-side cooling.

Powell acknowledged this distinction, noting that services inflation “has not really moved” and that the Committee would need “more evidence” before declaring the inflation fight won. The implication was clear: even if July proved to be the final hike, rates would remain at 5.25-5.50% for an extended period while the Committee waited for services inflation to respond to the cumulative tightening already in the pipeline.

What the Market Is Misunderstanding

“Peak rate” does not mean “imminent cuts.” The market’s instinct upon identifying the final hike is to immediately price the first cut. But the Fed’s framework requires sustained evidence of declining inflation before easing can begin. The gap between the last hike and the first cut could be 6, 12, or 18 months, depending on the inflation data. Investors who position for cuts immediately after the final hike risk being early by quarters, not weeks.

The lag effects of monetary policy are still building. Monetary policy operates with long and variable lags, typically 12-18 months between rate changes and their full economic impact. The bulk of the tightening (the 300 basis points of hikes delivered between June and December 2022) is only now reaching its full effect on the economy. The most significant impact of the tightening cycle may still be ahead, even though the hiking itself has likely ended.

The neutral rate debate matters more than the terminal rate. The critical question is not where rates peaked (5.25-5.50%) but where they will settle in the medium term (the neutral rate). If neutral is 2.5% (the pre-pandemic estimate), then current policy is extremely restrictive, and significant cuts will eventually be needed. If neutral is 3.5% or higher (as some Committee members believe), then the current rate is only moderately restrictive, and the scope for cuts is more limited. The answer determines the magnitude of the eventual easing cycle and the trajectory for long-term asset valuations.

Implications for Investors

Cash and short-duration fixed income offer the most attractive yields in 15 years. With money market funds yielding above 5% and short-term Treasuries offering similar returns, the opportunity cost of holding cash is near zero. For the first time since before the financial crisis, investors are being paid to wait, a luxury that should not be squandered by reaching for duration risk prematurely.

The equity market is priced for the soft landing. At approximately 20 times forward earnings, the S&P 500 is pricing an outcome in which the economy avoids recession, earnings continue to grow, and the Fed eventually cuts rates. This is a plausible outcome but not the only one. If the lagged effects of tight policy produce a more significant economic slowdown than expected, earnings estimates will need to be revised downward from levels that already assume resilience.

Quality matters more at the peak of the rate cycle. High-quality companies with strong balance sheets, low leverage, and durable competitive advantages are better positioned to weather an extended period of elevated borrowing costs. Speculative, unprofitable, and highly leveraged companies that survived through cheap capital face genuine solvency risk at 5.5% interest rates.

The dollar has peaked but will decline slowly. A Fed that has stopped hiking while other central banks continue to tighten implies a narrowing rate differential that should, over time, weaken the dollar. But the pace of dollar decline will be gradual, as the Fed’s “higher for longer” stance maintains the yield advantage that has supported the currency throughout the tightening cycle.

Conclusion

The federal funds rate at 5.25-5.50% represents the culmination of the most aggressive tightening cycle in four decades. The hiking phase is likely over, but the restrictive phase has only begun: the full impact of 525 basis points of tightening, delivered over 16 months into an economy still adjusting to the end of the zero-rate era, will take months to fully manifest. For investors, the peak rate is not a signal to immediately position for easing; it is a moment to assess the economy’s resilience under the full weight of monetary restriction and to prepare for an extended plateau before the eventual descent.

Related Reading

For how the hiking cycle began, see The Fed’s Most Aggressive Hiking Cycle. For the soft landing debate that followed, see Soft Landing in Sight?. For the eventual rate cut, see The Fed Cuts Rates: First Reduction Since 2020.