Landing Zone: The Fed, Inflation, and Market Volatility

On June 15, 2022, amid efforts to regain control over soaring consumer prices, the Federal Reserve raised its benchmark interest rate by three-quarters (0.75) of a percentage point, the largest interest rate increase in 28 years. The move followed a quarter-point (0.25) increase in March 2022 and a half-point (0.50) jump in May 2022. This recent interest rate raise will increase the Fed’s benchmark federal-funds rate to a range between 1.5% and 1.75%, the same level as in early March 2020 (the Fed usually gives a range for the rate rather than a fixed number).

The Fed made its biggest rate increase since 1994 partly in reaction to a three-day, 1900-point drop in the Dow Jones after newly released data showed inflation was stronger than expected in May. The S&P 500 had its worst first-half performance since 1970, down nearly 21% so far in 2022.

Fed chair Jerome Powell said the agency had decided to approve the larger rate rise because of concerns over recent data on inflation and expectations of future inflation, which economists say play a significant role influencing actual price rises.

Consumer prices in May 2022 were up 8.6% from May 2021. The increase, at the fastest pace in 41 years, reflected not only rising costs for gasoline and groceries, but also for rent, airfares, and a wide range of services. Rising prices have begun taking a toll on retail sales, which fell 0.3% in May 2022, with spending on furniture, appliances, and electronics declining.

Seeking a Soft Landing

By sharply raising interest rates, the Fed hopes to reduce consumer demand, which has overwhelmed supply and driven up prices. Higher rates will make it more expensive to carry a credit card balance, get a car loan, or purchase a house. Mortgage rates have risen sharply in anticipation; the average rate on a 30-year fixed home loan is near 6%, double what it was in June 2021, according to the New York-based consumer financial services company Bankrate. Sales of existing homes declined in February, March, and April 2022—the most recent period for which data are available.

Higher borrowing costs also affect economic growth. Fears that the Fed’s rate increases could tip the economy into a recession have roiled the stock markets.

In June, Fed officials projected the economy will grow just 1.7% in 2022, down from the 2.8% growth rate they were predicting in March 2022. They also raised their forecast for unemployment in 2023 from 3.5% to 3.9%, with a rise to 4.1% in 2024.

Growth is likely to slow further in 2023, narrowing the chance of a so-called soft landing, in which inflation falls without a recession.

The Fed is not finished with raising rates. “Clearly, [the June 15] 75-basis-point increase is an unusually large one, and I do not expect moves of this size to be common,” Powell said. But, he added, “from the perspective of today, either a 50-basis-point or a 75-basis-point increase seems most likely at our next meeting [over July 26 and 27].”

Powell said the central bank isn’t trying to induce a recession, but that achieving a soft landing is becoming more difficult—an implicit concession that the risks of a downturn could rise as the economy digests tighter monetary policy.

Minutes released from the Fed’s June meeting showed that officials see the interest rate peaking at around 3.75% by the end of 2023, up from the 2.75% rate that officials projected in March 2022 but slightly below what interest-rate futures markets had anticipated earlier.

Complicating the Fed’s efforts is emerging evidence that inflation may be peaking and the economy cooling on its own. Inflation is still high and May’s consumer price index level was disappointing, but recent producer price index data were better than expected on almost every score. In addition, price gains for goods are starting to decelerate as supply chains clear, inventories rebuild, and demand cools, as evidenced by weaker retail sales.

Inflation Is Global

Inflation rose in the U.S. sooner than in most other economies, possibly due to relatively strong demand from U.S. consumers and a more aggressive stimulus during the pandemic.

On a monthly basis, the consumer price index jumped a seasonally adjusted 1% in May after rising 0.3% in April, pushed by surging energy and food costs.

Energy prices rose in May as Russia’s invasion of Ukraine continued to push up prices for crude-oil and natural gas. Gasoline prices have reached record levels in recent weeks.

Consumers’ grocery bills have risen by an annual rate of more than 10%. Food price increases are unusually broad, and every single grocery category measured in the report rose in May 2022 from May 2021. The main causes for this increase were extreme weather, diseases affecting citrus trees and chickens, and the conflict in Ukraine.

The core-price index, which excludes the volatile categories of food and energy, increased 0.6% in May 2022, matching the increase in April. On a 12-month basis, the core-price index increased 6% in May, down from 6.2% in April. March’s 6.5% rise was the highest rate since August 1982.

Inflation has been afflicting countries around the globe. Recent inflation has been high through most major economies, with China and Japan the exceptions. In an analysis of 111 countries, Deutsche Bank found that the U.S. inflation rate sits roughly in the middle.

High inflation and rising interest rates remain the biggest threats to global financial markets in the second half of 2022. Rising interest rates slammed equity valuations in the first half of the year and growing economic concerns could slow corporate earnings and further pressure stock prices. In the near term, food and gas prices are likely to stay elevated due to the conflict in Ukraine, which could speed the transition to renewable energy.

While an easing of supply chain bottlenecks might be able to help ease inflation, it also could cause problems, potentially limiting pricing power and eating into profits.

The persistent sell-off in global markets has many investors fearing a U.S. recession. With some major indexes in or near bear-market territory, concern about a recession is valid; historically, eight out of the nine S&P 500 bear markets since 1950 have been associated with a recession. With growth concerns rising, the focus is shifting to the earnings side of the price-earnings ratio, and this could cause problems going forward.

Although the global economy is on relatively solid footing to withstand slowing growth, it faces notable headwinds. Consumers and corporations have plenty of cash and limited debt levels, and the general slowdown started during a period of rapid economic growth.

However, global central banks—led by the Fed—are tightening monetary policies aggressively, while governments around the world are pulling back dramatically on fiscal stimulus measures.

Much like the American conversation around rate hikes, the concern is that higher borrowing costs will also handicap growth prospects worldwide.

Following the Fed’s rate hike, the Bank of England moved to raise interest rates, the Hungarian central bank unexpectedly raised its one-week deposit rate, and the Swiss National Bank raised rates for the first time since 2007. The European Central Bank said it will move in July to raise rates, and speculation is building that the Bank of Japan—considered to be the most rate-hike-averse major central bank—may soon be forced into a hike as well.

No Crystal Ball

Inflation and low-but-rising interest rates may reduce return expectations while economic stress and interest rates in flux can mean higher than normal volatility for stocks and especially bonds. This situation leads to a dilemma for conservative and moderate investors.

Taking on moderate risk in a balanced portfolio is also challenging. Bonds are much more volatile than in the past, but still less risky than stocks, which are likely to remain relatively volatile. European equities may have higher expected return from their lower valuation but come with associated risks.

One constant in investing is that we do not know the future, and hence no single asset class can meet all investors’ needs. So, a portfolio optimized to balance the risk and reward trade-offs among many asset classes and over many uncertain market scenarios remains an important choice.

Because of this uncertainty, the best chance of retaining purchasing power over time is by staying invested in a diversified portfolio of stocks and bonds. Historically, diverse portfolios have always grown in value over time and have always recovered from periods of inflation and economic contraction.

The Fed will make every effort to prevent inflation by timing rate hikes. So, although the inflation rate is high and its impact is currently being felt strongly within households, this condition will come to an end at some point when the global economic regime transitions into its next phase.

It is also important to keep in mind that the quantitative tightening that the Fed is doing as it shrinks its balance sheet can be akin to rate hikes as well, and policy moves act with a lag, further clouding the outlook.

Inflation this cycle seems to be driven by things the Fed can’t control, such as geopolitics. What’s more, the Fed’s efforts to tighten financial conditions through rate hikes and balance-sheet reduction may not be the cure needed for today’s inflation, given that it was extreme levels of fiscal stimulus providing liquidity to households and markets—not excessive borrowing—that likely drove excess demand in the first place.

Economic information should not be ignored, but too often, statistics about the economy describe what has happened in the past rather than what will happen in the future. The Fed believes the economy is strong enough that inflation can be lowered to target levels with minimal economic damage and is eager to raise rates to a neutral rate, where inflationary forces are neutralized without unnecessary harm to employment or the growth rate of the economy.

Predicting the economic future is an inexact science, but an often-cited value of 2.4% is slightly below the market expectation for rate increases. The Fed is making decisions based on economic data and has no interest in causing unnecessary harm to the economy, so we can expect the number of rate increases to be reduced if there are signs of the economy slowing.

Bear markets don’t last. The Schwab Center for Financial Research looked at both bull and bear markets for the S&P 500 going back to the late 1960s and found that the average bull market ran for about six years, delivering an average cumulative return of over 200%. The average bear market lasted roughly 15 months, delivering an average cumulative loss of 38.4%. The longest of the bears was just over two and a half years—and was followed by a nearly five-year bull run. The shortest bear was the pandemic-fueled market in early 2020, which lasted a mere 33 days.

Conclusion: Stay the Course

We expect the Fed’s aggressive stance toward prices to lead to more volatility this year. Stock prices already reflect some economic weakness, but investors likely haven’t priced in the possibility of a recession or a significant slowdown in profit growth.

Resist the urge to sell. It’s difficult to time a perfect re-entry into the market. Market rebounds tend to be front-loaded. Missing those key days can have a big impact on performance. A diversified portfolio can help reduce the pain of volatility.

Don’t try to time the markets. It’s nearly impossible. It’s enticing to try to catch the next big investment wave (up or down) and allocate assets accordingly. But there are very few time-tested tools for consistently making those decisions well.

It’s important to consider how two impulses, panic, and greed, can work together, with yesterday’s greed paving the way to today’s panic. Investors may think they understand their risk tolerance—until they don’t. There’s a big difference between financial risk tolerance (the ability to financially withstand volatile markets) and emotional risk tolerance. The gap between the two is often quite wide and typically becomes evident in tumultuous market environments.

​Staying the course and continuing to invest even when markets dip may be hard on your nerves, but it can be healthier for your portfolio and can result in greater accumulated wealth over time.

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