The Fed Pivots

The US Federal Reserve changed the saving, lending, and investing landscape for 2022. The Fed pivoted on its view of inflation, and no longer is the word “transitory” found in its statement. The changes to the Fed’s policymaking meeting statement are outlined in a recent article. The fundamental differences are that with inflation continuing to rise and unemployment declining rapidly, the Fed will reduce bond-buying quicker and potentially raise interest rates three times in 2022. This change is a major policy shift that has implications for savers, borrowers, and investors. In addition, the moves should tamp down inflation.

Inflation is Surging

The Fed has a target for 2% core inflation. In its latest statement, the Fed acknowledged inflation had exceeded the target for some time. Core inflation as measured by the Consumer Price Index (CPI) was 4.9% through November 2021, excluding volatile energy and food prices. Inflation was even higher at 6.8%, including those two categories. However, there are signs inflation is slowing as energy, lumber, and other commodity prices have eased the past several weeks.

The Fed’s preferred gauge of inflation, the Personal Consumption Expenditures (PCE) Price Index, was at 5.0% in October 2021 and is expected to be 5.3% by year-end. However, the US Fed projects that inflation will be substantially lower at 2.6% next year, 2.3% in 2023, and 2.1% in 2024.

The primary reason inflation is surging is demand is outstripping supply for many items. A key driver is that labor is in short supply. The unemployment rate is again approaching the historical lows seen before the pandemic. The Federal Reserve projects that unemployment will be as low as 3.5% in 2022 and stay there until 2024. These numbers suggest that full employment has been achieved, one of the dual mandates for the Federal Reserve.

Source: Trading Economics

Many older workers left the workforce and realized they could make do taking early retirement. As a result, the workforce participation dropped from 63.4% to 60.2% and only recovered to around 62%. This percentage still leaves 1.6 million people out of the workforce.

Another key driver of inflation is tariffs imposed by the prior administration and mostly maintained by the current administration resulting in higher import prices. Yet another cause of inflation is delays and bottlenecks at ports, warehouses, trucking, and rail lines causing slow deliveries at higher costs. Supply chain challenges are usually addressed by sourcing materials, supplies, and other inputs from other countries. However, the global pandemic is affecting the global supply chain limiting flexibility resulting in price increases.

Tapering Doubles

The Fed started tapering in November 2021. Before this month, the Fed was buying $120 billion in bonds per month. This amount was lowered by $15 billion in November and another $15 billion in December. The target end date for quantitative easing (QE) was June 2022. However, the Fed announced on December 15^th it would reduce bond-buying by another $30 billion in January 2022, resulting in purchases of only $60 billion per month. This value is half of the dollar amount in October 2021. Hence, the Fed’s pivot means they will be on track to end QE by March 2022.

The goal of QE is to lower interest rates and promote borrowing and spending by consumers and businesses. For example, research has shown that QE during the sub-prime mortgage crisis lowered US Treasury yields, corporate bond yields, and mortgage rates resulting in more mortgage refinancing and bank lending. The bottom line was that borrowing costs were lower for consumers and businesses. In addition, this activity caused employment growth and a rise in the Gross Domestic Product (GDP).

Source: New York Fed

Hence, the logical conclusion is that a reversal of QE during the COVID-19 pandemic should increase yields and mortgage rates, acting as a brake on the economy. However, tapering is largely hypothetical since the last time it was implemented, the US experienced a taper tantrum.

Rate Increases May Happen

The Fed’s pivot means that rate increases may happen. At the December 15^th press conference, the Federal Reserve signaled three rate increases in 2022. The current Federal Fund’s rate is between 0% and 0.25%, a very low level. The Federal Open Market Committee’s (FOMC) dot plot has three increases in 2022, three more hikes in 2023, and two in 2024 based on median projections.

Implications for Savers, Borrowers, and Investors

A pivot in the Fed policy has implications for savers, borrowers, and investors. Savers should see higher interest rates making cash more desirable. However, real rates are still negative after considering inflation. 

Borrowers should see higher interest rates, especially in variable-rate loans. This point means auto loans, credit cards, and adjustable-rate mortgages (ARMs) will be more expensive for consumers. It also means refinance rates may rise.

Rising rates will theoretically make borrowing for businesses more expensive as corporate bond yields rise. This change may impact the ability of some companies to use debt to return cash to the shareholders. The bottom line is that companies with high levels of short-term or variable-rate debt will see higher interest costs and less cash flow for share buybacks and dividends.

Investors will be impacted as bond yields rise and prices come down. Long-duration bonds are more impacted than short-duration bonds. Riskier high-yield bonds tend to see sharp price declines because newer issued bonds have higher yields than older issued bonds.

Rising bond yields theoretically make higher-yielding stocks less attractive. Although, yields for utilities, real estate investment trust (REITs), and consumer staples stocks are still higher than bond yields in many cases. For example, the 10-year US Treasury yields only 0.93% lower than the S&P 500’s average yield of ~1.28%. However, banks may benefit from higher rates as the net interest margin spread between loans and deposits widen, making them more profitable.

Furthermore, tapering should lead to more stock market volatility. This event happened last time tapering was conducted and seems to be happening now, as demonstrated by the increasing volatility of tech and other growth stocks.

Final Thoughts on the Fed Pivots

Inflation started to show up early this year as the price of many basic necessities started to rise. However, Jerome Powell did not view it as sustainable at that time and forecast no rate hikes until 2024. This view point about inflation changed mid-year when the Federal Reserve indicated that there may be rate hikes in 2023. Now, the Fed is pivoting, which will have long-term implications for savers, borrowers, and investors. Interest rates will probably rise due to tapering. This rise will impact car loans, mortgages, and credit cards interest rates. Bonds will be impacted, as will stocks. Savers, borrowers, and investors should understand the implications and review their debts and investments.