Inflation, monetary policy, and interest rates
Although inflation has declined modestly since the beginning of the year, it remains unexpectedly high and persistent. There are multiple drivers of inflation, but the most important are the supply/demand dynamics in the economy that are manifested in commodity prices, consumer inflation expectations, money supply, and wage demands.
Commodity prices have declined materially since June, with a broad basket of commodities down 20%, and oil prices down 26% through the start of the 3rd quarter. Although commodity prices are a relatively small component in inflation statistics, they are an important indicator of underlying inflationary pressures. With global economies weakening, commodity prices seem poised to continue their descent from extremely high, pandemic-induced levels.
The war in Ukraine has had a major impact on commodity prices, especially energy. The outlook for this tragic conflict remains uncertain, with both Russia and Ukraine expressing their resolve to prevail. This major global uncertainty will continue to elevate the level of risk that financial markets must factor into asset valuation.
Consumer expectations of inflation, a key element of actual inflation, have diminished in recent months. Although this is a rather soft indicator, it is encouraging that it is showing moderation in the minds of consumers.
Even though consumer inflation expectations have dropped, their income expectations have not. Aggressive wage demands from workers remains the biggest obstacle to moderating inflation. Average hourly earnings for U.S. workers have been increasing at an annualized rate of more than 5%, double the average rate of wage growth experienced over the past decade. The labor market continues to be very tight, with unemployment close to the recent low of 3.5%.
Because inflation is a monetary phenomenon, the supply of money in the economy is a critical determinant of inflation. The dramatic tightening of monetary policy by the Federal Reserve (Fed) has essentially halted the growth of the money supply since early in the year. By reducing the basic monetary fuel that feeds inflation, the Fed hopes to bring inflation back down to a more acceptable level. However, it likely will take some time for tightening financial conditions to mitigate the long-term impact from the extraordinary amount of money that the fiscal stimulus and the Fed pumped into the system during the pandemic.
The Fed’s aggressive policy response to inflation in the form of sharp short-term rate increases has helped push interest rates to levels not seen in 15 years. Mortgage rates have more than doubled over the past year to around 7%. Sharply higher interest rates are showing signs of meaningfully slowing the economy, especially the housing sector. These higher interest rates are slowing economic activity as intended by the Fed; however, it will take some time for this moderation in economic activity to show up in the lagging inflation statistics.
In summary, the outlook for inflation remains challenging. Expect inflation to remain uncomfortably high well into next year. Although commodity prices have come down substantially and consumer expectations for inflation have become more benign, the labor market must show signs of moderating for the Fed to slow or pause its rate hikes. The Fed has been clear that it will continue with a restrictive monetary policy until inflation shows clear movement back toward its long-term target of 2%, which is a long way from current levels of inflation.
When will the bear market end?
There are some important conditions that need to be in place before the markets can fully recover:
- As mentioned, inflation needs to show signs that it is not just moderating but is moving substantially lower. There are some very early indicators that moderation is happening with commodity and housing prices, but the labor market needs to show signs that spiraling wage demands are diminishing. Unfortunately, this means unemployment levels need to move higher. Currently there are a few early indicators that inflation will moderate, but not to an extent yet that will be immediately favorable to the market.
- Closely tied to inflation is the Fed’s reaction to inflation in the form of 1) less hawkish rhetoric, and 2) a clear indication that it is done raising interest rates. Fed policy remains restrictive and, thus, problematic for the market. The Fed has indicated that more interest rate increases may be forthcoming into 2023. However, some stresses globally are now becoming evident, especially in the currency markets, as the U.S. dollar has vaulted to levels not seen in nearly two decades. These may be early signs that the aggressive policy actions are having some significant effects. However, the Fed is not yet ready to pivot to a more accommodative stance.
- The bond market had shown signs of improvement during the first part of the 3rd quarter, as interest rates and credit spreads moved lower. However, like the stock market, the bear market in bonds resumed, with bond yields pushing higher to 4 - 9%, depending on maturity and credit quality. The bond and credit markets need to stabilize before the stock market can decidedly emerge from this bear market. Short-term bond yields have already factored in 125 basis points of additional Fed tightening. Credit spreads, although weak, have not widened in a disorderly sell-off and remain well below recessionary levels.
Bear markets historically last about a year, with an average peak to trough decline of about 32%. This bear market has reached about 75 - 80% of those historical metrics. If history repeats itself, this bear market could be expected to have run its course roughly around the 1st quarter of 2023. This timing also would align with the Fed’s projections of when short-term rate hikes will be ending.
What to expect from the key market sectors?
- Rates. We expect the Fed to pause early next year and cut rates later in 2023. The Treasury yield curve should remain inverted, as short-term rates remain anchored by Fed rates and longer-term rates stabilize and then decline, reflecting slower economic growth.
- Equities. We expect that the uncertainty over the path of inflation and interest rates will diminish toward the end for 2022 and into the first part of 2023. That should set the stage for markets to recover. Equity markets historically have not sustainably rallied from bear market lows until the Fed has stopped raising rates and begun cutting rates.
- Credit. Credit sectors, such as investment-grade corporates and high yield bonds, offer attractive yields not seen in years. Credit spreads, an indicator of risks such as default, have widened but remain below recessionary levels. We expect spreads to widen into next year as the economy slows before stabilizing and rallying. We are closely watching credit spreads as they often foreshadow equity moves.