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What will it take to tame inflation?

The Fed is acting faster than anticipated, leaving investors to face stronger headwinds.


 

Our Top Market Takeaways for Jan 14, 2022.

Market update

What will it take to tame inflation?

Do you really want to know? This week, inflation data from December confirmed that consumer prices are rising, and fast. Overall prices popped 7% in 2021—the highest reading since 1982. The core measure, which excludes food and energy prices, rose 5.5%.

In many cases, inflation is eating into the tremendous nominal gains the U.S. economy has made since reopening started in the spring of 2020. Average hourly earnings haven’t grown after adjusting for inflation in over eight months. The University of Michigan’s Consumer Sentiment survey suggests that Americans are just as down on the economy now as they were at the beginning of lockdowns in March and April of 2020. President Joe Biden’s approval ratings, especially on his handling of the economy, are deeply underwater, and inflation is stalling his broader economic agenda.

Now, policymakers seem intent on taming inflation. In their congressional testimonies this week, both Federal Reserve Chair Jerome Powell and Vice Chair nominee Lael Brainard forcefully acknowledged that the Fed is planning to raise rates this year in an effort to get inflation in check.

But what does it really take to tame inflation?1

The Fed typically needs to raise interest rates to a level that discourages borrowing, investment, hiring and spending. This means higher mortgage rates, lower asset prices, slower jobs growth and a weaker consumer. Former Fed Chair Paul Volcker famously beat back the inflationary spiral of the late 1970s by raising the federal funds rate from 10% in 1979 to 20% in 1981, but the price he paid was a double-dip recession that saw unemployment peak at 11% and the S&P 500 decline by over 25%.

The good news for this Fed is that its task will probably be easier than Volcker’s. First, long-term inflation expectations derived from fixed income markets suggest that investors are still expecting this bout of inflation to be transitory. Further, it is hard to find good evidence from corporate surveys that a wage-price spiral is percolating. Finally, and most importantly, consumer price inflation is still largely being driven by durable goods that are impacted by strong demand from consumers, supply chain issues that are exacerbated by the ongoing pandemic, and input shortages whose roots go back to the trade war and beyond.

As we move through 2022, it seems very likely to us that goods inflation will cool (there are signs of softening in important areas such as used cars, and supply chain disruptions from COVID-19 should alleviate as we march further and further toward endemic disease). It is also possible that wage growth levels off as employers find the new clearing price for labor in pandemic-disrupted industries (such as hospitality and healthcare). The inflation picture could look much better as soon as this summer, when the year-on-year comparisons will be much more difficult to exceed, and it won’t have much to do with the interest rate hikes the Fed has planned.    

Markets are starting to calibrate to a more aggressive monetary policy pivot, but they don’t seem to believe the Fed will have to break the economy. In fixed income, the market-implied probability of an interest rate hike in March is above 90%, and 10-year bond yields have risen to their highest levels since March 2021.

In equities, the assets most vulnerable to tighter policy have already broken. SPACs, recent IPOs, the ARKK complex, stay-at-home winners, unprofitable software and clean energy are like straw houses already blown down by the Big Bad Wolf. Even the Nasdaq 100 (-5%) has been under pressure so far this year.

Meanwhile, assets that are tethered to global economic growth are still well supported. Global banks are trading at their highest levels since the global financial crisis. Emerging markets have outperformed the S&P 500 so far this year. A barrel of crude oil is back above $80, and copper prices are elevated.

We tend to agree with the market’s assessment. There is probably still a long way to go before the fight against inflation breaks the economy. Four 25 basis point rate hikes this year probably won’t be enough to dissuade corporate management teams that are flush with cash from committing to capital expenditures that expand capacity or increase automation. Millennial families that are seeing strong wage gains probably won’t be discouraged from buying a new home because of moderately higher mortgage rates. A more aggressive Fed is a headwind to stocks, but a strong economic and earnings backdrop should carry the day.

As the year progresses, we will have to assess whether the Fed will need to actively restrict growth, and break the economy, to tame inflation. For now, we think there are enough ways for inflation to recede toward more tolerable levels without an aggressive intervention. Investors can still favor stocks over bonds, but portfolios will have a stronger headwind from the Fed than we expected when we wrote our 2022 Outlook a few months ago.

To hear some ways you can prepare for higher interest rates, please get in touch with your J.P. Morgan team.

1.This title is a reference to Spencer Hall’s 2016 essay Do you really want to know what it takes to beat Alabama?, one of my favorite pieces of writing ever. This year, of course, Georgia found out what it takes. Congrats to the Dawgs.

 

All market and economic data as of January 2022 and sourced from Bloomberg and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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All market and economic data as of January 2022 and sourced from Bloomberg and FactSet unless otherwise stated.

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