Capital Ideas^TM

In a world of rapidly escalating prices, Russia’s invasion of Ukraine has exacerbated inflationary pressures. We have seen a direct impact on energy and a broad swath of agricultural commodities, and are likely to see a broadening of price pressures. 

Supply chain bottlenecks, another significant source of inflation over the past year, are likely to worsen as a result of sanctions against Russia. And while the world has been focused on the terrible conflict unfolding in Ukraine, another COVID-19 outbreak in several cities in China has stymied economic activity, leading to further disruptions. Meanwhile, house prices continue to rise at a rapid pace. Given these developments, it has become plain to even the most casual observer that monetary policy in most major economies is behind the curve.

The rapid rise in inflation is staggering. In February 2021, the headline CPI inflation rate in the US was only 1.7% year-over-year. It rose steadily over the ensuing months to 5.4% in June 2021. As inflation remained stubbornly above target and the unemployment rate continued to fall, the Fed made a substantial pivot and began to prioritise fighting inflation over supporting growth. But there was still substantial uncertainty as to how aggressively the Fed would act. 

That is no longer the case. As we all know, at the recent Fed meeting on 16 March, with inflation at a 40-year high of 7.9%, the Fed hiked interest rates by 25 basis points (bps). Chair Jerome Powell, in subsequent hawkish comments, made it very clear that the Fed was going to do what it takes to try to reduce inflation. The Fed’s latest projections indicate that it may raise rates above its estimated long-term neutral rate of 2.4% by next year. (The neutral rate is a theoretical federal funds rate at which monetary policy is considered neither accommodative nor restrictive.)

Powell appeared to have high confidence that the US economy can not only withstand but flourish under tighter monetary policy. This indicates to us that the Fed does not seem concerned about the potential impact to growth that could come from tightening financial conditions. As such, barring a major fundamental shock, I expect that the Fed will continue on its tightening path for the rest of 2022. Markets are currently pricing in about eight additional 25 bps rate increases over six scheduled Fed meetings in 2022. The market now expects at least two 50 bps hikes in the coming meetings and, if inflationary pressures stay persistent or rise from today’s very high 7.9%, the Fed could easily continue at that pace for longer.¹

With growth already slowing following the 2020 stimulus and economic recovery, I believe that hawkish monetary policy and tighter financial conditions will further reduce growth expectations. We have seen a compressed economic cycle in the COVID/post-COVID period, progressing from recession, to early-, to mid-cycle in less than 12 months. Whether the next economic slowdown turns into a mild or more significant recession will depend to an extent on the pace of Fed tightening.

Over the past six months, valuations have declined from ultra-rich levels across fixed income sectors. I still view them to be slightly expensive given the rise in implied market volatility and the Fed’s determination to bring down inflation. At the same time, as when prices move to adequately reflect the uncertain environment, we are using bouts of market volatility to selectively add to riskier positions at more attractive levels.

 

1. As at 23 March 2022

 

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• This material is not intended to provide investment advice or be considered a personal recommendation.
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