As investors wait for inflation to settle down, diversification and rebalancing provide better protection than market timing. We explore the economic threats that make this protection necessary.
Following the financial markets during 2022 has felt a lot like watching one of those cliffhanger movie endings that keep viewers on the edge of their seats until the credits roll. Will the forces of good defeat the evil inflation without subjecting the economy to a painful recession? The next six months will likely tell us how the tale ends.
The three main characters in our saga are Federal Reserve chair Jerome Powell, Russian president Vladimir Putin, and Chinese president Xi Jinping. Other characters contribute to the storyline, but these three have driven the inflation narrative in 2022. That trend is expected to continue, if not accelerate, in the second half of the year. Let’s look at each of them individually to see where the story may take us.
Will Powell save the US economy from the worst?
Inflation became a problem in the second half of 2021 as COVID-19 restrictions started to loosen and the US economy opened. Personal Consumption Expenditures (PCE), the Fed’s preferred measure of inflation, was approaching 6% by December, nearly four percentage points over the Fed’s stated target of 2%. Powell signaled then that the Fed would start to tighten monetary policy aggressively. At the time the target range for the federal funds rate was 0.0% to 0.25%.
Our 2021 year-end outlook predicted that Fed actions would dominate headlines in 2022. Unfortunately, that prediction has turned out to be accurate so far. The market currently estimates that the federal funds target has a 75% chance of falling between 3.25% and 3.75% after the December 14 Federal Open Market Committee (FOMC) meeting, the last of the calendar year. That target implies a minimum 3.25% rate increase in one calendar year. The last time the US economy experienced a rate increase that large in a 12-month period, Paul Volcker chaired the Fed, leg warmers were in style, and “Endless Love” topped the charts.
Keep in mind that at the same time the Fed is aggressively increasing interest rates, it’s also shrinking its balance sheet—known as quantitative tightening—initially by $47.5 billion per month. That number is expected to increase to $95 billion per month, starting in September. Powell has put price stability at the top of the Fed’s agenda, and he’s working to achieve it. But what does that imply for the future?
Inflation as measured by Personal Consumption Expenditures (PCE), 2013–2022
Source: Federal Reserve Bank of St. Louis, 3/1/2022. For illustrative purposes only.
As the impact of higher interest rates and quantitative tightening works its way through the US economy, we’ll likely see reduced demand and slowing growth. The sell-off in the equity market, which has now reached bear-market territory, is pricing in this economic slowdown. The Fed is hoping for a soft landing, with only a modest uptick in unemployment. A soft landing would mean the economy remains resilient in the face of more restrictive monetary policy, unemployment ticks up but generally remains low, and inflation reverts to the 2% level as supply and demand achieve an equilibrium. In this scenario, the yield curve steepens, and equities begin to recover.
The alternative to a soft landing is, of course, a hard landing. In this scenario, inflation remains more entrenched in the economy, forcing the Fed to tighten even more aggressively as we enter 2023. The result is the US economy falling into a recession and unemployment rising sharply. The transition to a restrictive monetary policy puts pressure on financial and housing assets that impact consumers’ balance sheets, causing a further reduction in spending. The yield curve continues to flatten, possibly inverting, while equities remain under pressure.
Obviously, many scenarios lie in between a soft and hard landing. As the leader of the Fed, Powell will be the central figure in the battle with inflation. Can he thread the needle and rein in inflation without seeing the US pushed into a recession? That outcome will in part depend on others.