What Does the Fed’s Hawkish Pivot on Inflation Mean?

The rapid shift in tone from the Federal Reserve on inflation, and its planned course of action in response to it, has been stark. But this is just the beginning of what is likely to be a lengthy process to unwind years of monetary policy.

Hawk flying

The Federal Reserve met last week and made announcements that, while expected, have had an impact on both the markets and the economy. The Fed’s goal is to allow enough inflation so that the economy can recover and grow. The challenge is that the economy may overheat, causing spiking inflation that requires drastic action on interest rates. On the other side, too aggressive action on interest rates, and too soon, can cut off the recovery and lower growth. The Fed has been clear that it is, and will remain, guided by data. In action, this means that the economy’s changing needs will dictate Fed policy as new data comes in, rather than the Fed holding to a discrete goal. The continued increase in inflation, along with other measures indicating strength in the economy, has led the Fed to conclude that guidance on two more rates increases in 2022, for a total of three, is in order.


The Fed delayed until November to introduce the specifics of a tapering process to remove liquidity from the economy. After just one month, it has now increased both the timing and the amounts of the reduction in asset purchases. The original almost nine-month schedule of declining asset purchases has been reduced to five months. In only the second month (December) purchases will decline by double the amount of November. What does all this mean? We dive in.


The Fed Says It Out Loud on the Likely Duration of Inflation


In earlier testimony to Congress, Fed Chairman Powell indicated that the “transitory” language in the Fed’s statement on inflation should be retired. The Fed made this formal in the recent statement. To most observers, this has seemed obvious for months as inflation continued to rise and supply chain and labor force issues proved stubborn to resolve.


This doesn’t mean we’re in for a period of 1970s-style inflation. Supply chain issues are resolving, only slower than anticipated. Only Core Goods inflation, which is most impacted by the problems in sourcing, has experienced the massive uptick. Core Services inflation is still essentially flat. This gives weight to the argument that a return to normalcy will bring inflation down rapidly.


Why is Tapering Important?


Early in the pandemic, the Fed moved incredibly quickly to pump liquidity into the economy to keep the system moving. Interest rates were cut to zero, and because the economy needed additional help, the Fed began to purchase $120 billion Treasury and agency mortgage-backed securities each month. This kept the price of long-term assets up, and since price moves inversely to yield, it lowered long-term interest rates. This made business and consumer debt more affordable and helped keep the economy moving. The Fed’s continued asset purchases also signaled to the market that it was committed to supporting the economy, further raising confidence. The Fed left interest rates unchanged at the recent meeting but doubled the reduction in asset purchases to $30 billion less in December, from a decrease of $15 billion in November. The new intention is to wind up tapering in March rather than in June as originally planned. Without further asset purchases, the next step is to increase short-term rates.


Interest Rate Increases


Chairman Powell has indicated three interest rate hikes in 2022, and three rate hikes in 2023 and two in 2024, for eight total. Assuming a 25 basis point hike each time, that puts short-term interest rates at a minimum of 2.00% by the end of 2024. Of course, the Fed could decide to increase either the amount of the rate bump or add additional hikes, depending on the data.

What Does This Mean for Investors?


Consumer balance sheets are first up. With rates increasing, credit cards, personal debt and mortgage debt will begin to go up. If you’ve been taking advantage of low credit card debt or have availed yourself of a new card that came with an introductory period of no interest charges, it will soon be time to pay the piper. Reduce balances now, or at the very least increase savings so you can pay them when rates go up. If you’re thinking about buying or refinancing a home, it might be a good idea to act on it. Higher rates may have some damping impact on the booming housing market, but unless you have excellent credit whatever you save in the purchase price you may end up giving back in interest charges.


The Fed “tapers” asset purchases due to a fear of a “taper tantrum” when too-quickly reduced asset purchases have a knock-on effect on the equity markets. With inflation still high and liquidity less easy to come by, companies will have a harder time. But besides extending the run that value stocks have seen this year, there may not be any portfolio positioning that needs to take place. Many investors are already defensively positioned against inflation at this point in the cycle. Holding stocks with pricing power that can ride out inflation will continue to be a wise choice.


The Bottom Line


Just like the robins arriving signals Spring, the Federal Reserve realigning monetary policy for a new reality is the first sign that the economy is rounding the first corner. The recovery continues, and investors should begin to think about a new turn of the business cycle – but as always, keeping a long-term plan in place is the best way to achieve your goals.

 

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The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.

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