Higher and Faster: The Fed Turns Up the Heat

Featured Post | Published at Apr 29, 2022, 12:00 AM in investment strategy by Nick Maratta

With one 25 basis point rate hike in place, the Fed is already indicating that at the May Federal Open Market Committee (FOMC) meeting, the key short-term interest rate will jump substantially. In recent remarks, Federal Reserve Chairman Powell said the Fed would be "moving a little more quickly." The first 50 basis point hike in 22 years is the start of the new timeline for how high rates will likely get and when.

At the same time, the Fed plans to begin “quantitative tightening,” which is the process of reducing assets held on the Fed’s balance sheet. The Federal Reserve is holding close to $8.5 trillion in U.S. Treasury and agency and mortgage-backed securities, which it began purchasing at the beginning of the recession to pump liquidity into the system. This kept prices up, which lowered yields.

The Fed has announced a plan to begin letting the Treasuries roll off its balance sheet as they mature and will sell agency and mortgage-backed securities. After the Global Financial Crisis, rates increased much more gradually, and quantitative tightening did not begin for several years. This time around, the Fed is undertaking both actions simultaneously.

The Inflation Fight Gets Real

Why the urgency? Annualized inflation hit 8.5% in March, the highest in 40 years. Added to that is the disruption caused by the war in Ukraine, which is hitting supply chains, food, and energy prices. The other side of inflation is the labor market. The Bureau of Labor Statistics reported in early April that total nonfarm payroll employment rose by 431,000 in March, and the unemployment rate declined to 3.6 percent. This is just a hair above where unemployment was before the pandemic.

The labor market's strength is a positive for the economy, of course, and full employment – and wage increases that will help reduce economic inequality – is one of the Fed's stated goals. The Fed is attempting to balance monetary policy such that inflation will moderate and the economy will keep growing, even if at a slower pace.

The war in Ukraine isn't just hitting inflation; it's also projected to impact growth. The International Monetary Fund released a new report that quantifies the likely effect of the war. The IMF is projecting that global growth will slow from an estimated 6.1% in 2021 to 3.6% in 2022 and 2023. This is 0.8 and 0.2 percentage points lower for 2022 and 2023 than projected in January.

Is Stagflation on the Cards?

The question for investors is whether inflation has peaked – or if we are headed into a "stagflation" environment. Stagflation is defined as high inflation, high unemployment, and slow or negative real economic growth. The pessimistic view is that the Fed will overshoot on interest rate increases, driving the economy into recession. This would likely reverse positive labor market trends. Added to the ongoing high prices, stagflation could result.

However, stagflation isn’t likely. Outside of food and energy, the other inputs to Consumer Price Inflation (CPI) all decreased in March. Supply chains are resolving, and the Institute for Supply Management reports that inventories are rebuilding. This will also help bring down prices. Labor shortages are not likely to ease soon, and growth, while expected to moderate, is still at or above the long-term trend.

What Can Investors Expect?

The problem for markets is exactly that – they don’t know what to expect. Circling back to the Fed, with only one rate increase enacted so far, we can't see the impact. Markets are already pricing in the higher rates, and rates will likely go higher with the announcement of one or several 50 basis point hikes. Bond yields are already up over 100 basis points in the last few months, and mortgage rates are currently over 5.00%, another significant increase in a short period.

Tighter money supply is difficult for equities, and even with the increase in rates, yields on fixed-income securities are so low that higher rates aren't as helpful, and the corresponding decrease in prices (bond yields move inversely to their prices) hurts overall return.

However, equity markets have seen record earnings for the last several quarters, and the current earnings season is shaping up as well. As of April 25th, approximately 20% of S&P 500 companies have reported first-quarter results. Of those, 76% have met or exceeded expectations on revenue and 82% on earnings. Companies have successfully passed costs on to consumers and are likely to continue to do so.

Are There Tactical Steps to Take?

When it comes to riding out volatility, as a consumer, saver, and investor, there are many things to do. The most important thing is to review your goals. As long as nothing has changed, and your plan was set up with those goals in mind, the best action is to take a step back.

Your long-term financial plan should be built to withstand shocks, and so far, there's no indication that selling everything, buying crypto, and building a bunker in your backyard is the way to go. There are some moves to make to tune up your portfolio. For instance, consider holding slightly more cash than usual. If you usually invest a tax return or other considerable amounts in one lump sum, consider dollar-cost averaging to get invested. But cutting back on 401(k) contributions, 529 plans, or HSAs doesn't make sense from a long-term perspective. On the consumer side – debt was never your friend, and it's actively eating your wealth now. Pay down high-interest debt as quickly as you can.

The Bottom Line

We’re clearly in a new monetary policy regime, and the war in Ukraine has made the inflation battle harder and has increased the uncertainty. We may be at peak inflation, and we'll see the Fed's efforts bear fruit. It's just too early to tell. As always, the long-term perspective is the best way to keep your cool and keep your balance.