Policy Mistake Anxiety

Policy Mistake Anxiety

January 19, 2022

As we have been sharing with clients, 2022 looks to be a year where broadly we expect the market to make positive moves, but we also expect to see a lot more bumps in the road than last year. And sure as the sun shines, this first two weeks of the new year have brought rising interest rates and sliding major market indices.

 One reason for the increased volatility could be investor anxiety about a possible “policy mistake.” We are beginning to see the term pop up in market commentary, but you might wonder what analysts are referring to when they mention a policy mistake. In a nutshell, a policy mistake would be defined by the Federal Reserve raising interest rates too sharply or too quickly, or conversely, not high enough, fast enough. Unfortunately, this a bit like hot salsa tasting. You’ll never know if you made a tasting mistake, too much or too spicy, until the chile hits the tongue. Then it’s too late. Pass the milk.

 The fed recently has begun to change its stance with regard to its dual mandate; full employment and price stability. Whereas its focus since the pandemic began has been providing as much support to the economy as possible to reach full employment, the focus has now begun to swing toward price stability or fighting inflation. And the tools for fighting inflation are limited. They have started to use the first, managing their own balance sheet, by reducing their bond purchases. The second tool, the setting of fed funds rate, could come in to play as early as March. At least that’s what the market seems to be expecting.

 Given that the major drivers of inflation in the current economy are on the supply side, mostly complicated by pandemic effects on supply chains, it is an open question as to how much higher interest rates will help to slow the increase in the consumer price index. The reason higher interest rates normally are used to slow inflation is because an economy that is running hot, where inflation typically becomes an issue, is also accompanied by an overall increase in debt levels. The chart below shows US household debt to GDP.

 

 

Notice how since 2009 households have been clearing debt substantially. Higher interest rates are used to slow down an increase debt. But what will they do in a situation like this?

 The pandemic has also created some serious imbalances in what consumers are spending on. Services used to lead, and now it is durable goods, like cars and electronics, that are leading the categories. This, coupled with supply chain disruption, has led as much to inflation as the higher cost of energy.

 It might be a while before we see an actual hike in interest rates, but determining whether that will be a policy mistake, or not, will only be known in hindsight. As a consequence, every data point related to inflation, retail sales, wage growth and energy pricing will likely cause some further bumps in the road.

 What should investors be doing? Give us a call. We’d love to talk about your particular situation.

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

 The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

 The companies presented here are for illustrative purposes only and are not to be viewed as an investment recommendation.