Millions of Americans are feeling the tangible effects of increased pricing on everything from strawberries to interest rates. In the throes of a global pandemic, inflation has accelerated in recent months prompting Americans to take stock of their day-to-day purchases and pushing the Federal Reserve to reassess their strategy for the new year. Already in the first few days of this year, the 10-year treasury rate has gapped to an eight-month high and mortgage rates are back to their highest levels since the spring of 2020. What more can we expect from the impact of inflation in the new year?
After several months of maintaining that the recent rush of inflation is “transitory,” the Federal Reserve opted to leave the term out of its December meeting minutes, now acknowledging that inflation levels exceeded their expectations and that, “it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated.”
Just one month into 2022, Bank of America Economists reported that the Federal Reserve is expected to hike interest rates at each meeting through the remainder of the year to combat inflation. Economists are predicting seven quarter percentage point increases in 2022, landing between 2.75 and 3% come 2023.
The market is pricing in a 67% probability of a 25bp increase at that policy meeting. In fact, two-thirds of the Fed officials are anticipating three rate hikes this calendar year, and on average, the Fed expects three more in 2023.
While the timing and frequency of the rate hikes will likely garner the bulk of the attention, equally and perhaps even more important, is the Fed’s normalization of its balance sheet, consisting of treasuries and mortgage-backed securities, which grew from about $4 trillion to nearly $9 trillion during the pandemic.
Essentially, the Fed will seek to reduce its balance sheet through two means—by selling securities and/or avoiding the reinvestment of securities as they mature. The Fed’s current average weighted maturity of its securities holdings is shorter than when previous efforts were made to reduce the balance sheet (following the Global Financial Crisis), implying that it could shrink faster and also signaling the central bank’s confidence that the current economic recovery has sufficient momentum to withstand aggressive tightening measures.
As the Fed withdraws its support from the bond market, yields suppressed through its quantitative easing measures will reverse course and there will be upward pressure on interest rates as investors position themselves for the Fed’s pivot on policy.
Related: How to Take Advantage of Inflation
While the Fed has expressed its efforts to tighten monetary policy, there are other factors contributing to inflation that will likely keep prices elevated.
There are supply chain challenges that will still take significant time to work out. Not enough trucks are being produced due to a global chip shortage that isn’t going away anytime soon, and there aren’t enough drivers to operate those vehicles in part due to the California AB5 law that was put into effect just weeks before COVID started.
Furthermore, port blockages were a major problem as best highlighted by the Ever Given that was stuck in the Suez Canal last March. Washington is putting in place a number of reforms, such as through the Infrastructure and Jobs Act and the Ocean Shipping Reform Act that was recently passed in December. The new legislation will take time to mitigate the existing supply chain concerns.
Additionally, inflation will continue to get pushed higher as residential leases reset and rents are driven up by higher home prices, which rose over 18% last year, according to Case-Shiller. The home price appreciation has not yet been fully reflected in rents, and housing costs account for over 40% of the consumer price index.
Fed officials are aiming to reduce inflation to 2.6% by the end of 2022, compared to their current preferred price index level that rose 5.7% through November. Achieving this level of price stabilization seems ambitious and would likely require aggressive action in the face of the aforementioned inflationary forces.
On the bright side, a number of economic factors point to continued growth in 2022. Analysts forecast US earnings to grow another 9.2% this year, which would well outpace the average of the previous decade. Furthermore, with demand for workers at historical highs, the national unemployment rate fell to 3.9%, moving below 4% for the first time since the pandemic began. By year end, unemployment is forecast to fall to 3.5%.
According to the Conference Board, after seeing GDP growth of what is likely to be 5.6% for 2021, they forecast the economy to expand another 3.5% in 2022, which would be quite strong relative to recent history. Wall Street firms are even more optimistic, forecasting for 3.8% growth on average. Whether such developments mean good news for investors remains to be seen, but the real economy is generally expected to be healthy this year.
Compared to what we might have expected 18 months ago, we remain far behind in progressing beyond the pandemic with regards to achieving endemicity or herd immunity. At the same time, our economic recovery has far exceeded even our most ambitious initial targets. This counterintuitive confluence of events means that while we remain hopeful that businesses and daily life continue to normalize, investors should be cautious as we confront the prospect of coping with the most rapid pace of monetary tightening in decades.
Given the backdrop of extraordinary returns in recent years, the considerable optimism already priced into financial markets, and the significant ramp up in retail speculation through apps and option trading, investors may want to be more modest in their target objectives this year. Coping with case surges is something we have recent familiarity with, which society is largely handling in stride. Coping with a decidedly hawkish Fed is not, and volatility is to be expected. Have questions related to inflation or investing in 2022? Connect with our team and speak to one of our experienced financial advisors.