INVESTED: In Markets, in the Future, and in Society.

FOMC Gymnastics and a Potential Policy Misstep

Author: Keith McLean — Executive Vice-President

With a very difficult start to 2022 for both equity and fixed income markets, investors have been reminded of the adage “Don’t fight the Fed.” Dr. Martin Zweig is largely credited with coining this phrase in his 1970 book, Winning on Wall Street, in which he explains the importance of monetary policy to stock market returns; particularly, the easing and tightening biases of the Federal Reserve. The Federal Reserve is the central bank of the United States and controls monetary policy for the United States. It was established in 1913 to influence the availability and cost of money and credit to help promote national economic goals.

Although blindly “following the Fed” has never been a perfect investment strategy, understanding the directional bias of the Federal Reserve and “not fighting the Fed” has been an important factor in successful investing for over 50 years. According to Deutsche Bank research referenced by Fortune, there have been 13 separate tightening cycles since 1955. During the initial year of the average 2-year rate hike cycle, investment returns on the S&P 500 were decent, averaging 7.7 percent.

However, only the most recent Fed tightening cycle from 2015 to 2019 also had to consider “quantitative easing” and the balance sheet of the Federal Reserve. The Fed’s implementation of monetary policy evolved considerably after the 2008 financial crisis. Between 2008 and 2014, once the Fed implemented a “quantitative easing” strategy to expand its holding of longer-term securities, its balance sheet grew from under $900 billion to $4.5 trillion. These open market operations (OMOs) were used to make financial conditions more accommodative to support economic activity and job creation by putting downward pressure on longer-term interest rates. During most of the 2015 to 2019 tightening cycle, the balance sheet remained stable, with no real “quantitative tightening.” During 2018, the Federal Reserve balance sheet finally began to shrink from $4.5 trillion to $3.8 trillion before quantitative easing was again implemented in late 2019. Since then, the COVID pandemic has seen the Federal Reserve balance sheet balloon to almost $9 trillion.

There are at least five factors which make the currently projected tightening cycle more difficult to interpret. First, we have experienced an inflationary spike not seen in over 40 years. This spike was initially labelled as “transitory” by the Chair of the Federal Reserve, Jerome Powell. However, it has been much more persistent and has run higher than most, in the last few months. We have witnessed higher U.S. inflation prints in six successive months, culminating with a measure of 7.5 percent in January of 2022. This is a level of inflation that has not been witnessed in 40 years and has forced the Federal Reserve to act decisively.

Secondly, it has been signalled that this will be the first tightening cycle ever implemented that could see simultaneous monetary tightening and quantitative tightening. There is almost no debate that the Fed will begin monetary tightening and has signalled the expectation to see numerous rate hikes across 2022 beginning in March. The Fed has communicated that the market should expect less quantitative easing moving forward and that the balance sheet should begin to shrink by late 2022 as current bonds held start to reach maturity.

Thirdly, the world continues to experience COVID-related supply chain disruptions. There are numerous areas of the economy that continue to see significant interruptions, but the most obvious example is how semiconductor shortages have caused dislocations for automobiles, computers, appliances, and other manufactured goods. These dislocations have led to significant price spikes for new and used vehicles and have caused inflation in many other areas. These supply chain disruptions should begin to mitigate in 2022 and have a naturally dampening effect on inflation.

Fourthly, most market participants believe the Fed has let inflation run too far, too fast, and is now well “behind the curve.” Reacting to already high inflation by raising rates is a policy error that could lead to several problematic outcomes. If the economy has already begun to decelerate due to higher prices, then raising rates in that environment could lead to a recession.

Lastly, the timing of Russian President Vladimir Putin’s brinkmanship over the Ukraine could not come at a more challenging time for the Fed. The geopolitical complications of a European war and the related trade sanctions will also have to enter the already complicated calculus of the Fed.

With all of these factors to consider, there is a good chance that the Fed could make a policy misstep that has negative implications for asset prices. The crystal ball is never clear; unfortunately, it may be cloudier than normal these days. As such, investors may want to re-evaluate their portfolios to ensure that they have an asset mix that balances various macroeconomic risk factors – including a potential Fed policy error.

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