Sean F. from Savannah, GA asks: Hi Mitch, I’m writing to ask for your thoughts on the latest Federal Reserve comments, regarding interest rate increases sooner than later. The markets seemed to sell off on the news and have been a bit volatile since. Will this be problematic in 2022?
Mitch’s Response:
Thank you for emailing your question. The Fed minutes from their December 14-15 meeting certainly made a splash in the headlines last week, and for good reason – Fed monetary policy impacts the economy.1
For readers who may have missed the announcement last week, we know based on the Fed’s December meeting that the central bank is no longer comfortable waiting for inflationary pressures to ease. Here are some key quotes from the meeting:
- “[Fed] participants generally noted that…it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated.”
- “[Some Fed participants deem it] appropriate to begin to reduce the size of the Federal Reserve’s balance sheet relatively soon after beginning to raise the federal funds rate.”
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Trading in interest rate futures indicates an approximately 70% probability the Fed would increase the fed funds rate at or before their March meeting, a greatly accelerated timeline from expectations just two months ago. It is also worth noting that the decision to potentially begin shrinking the size of the Fed’s balance sheet soon after rate increases are new – during the previous rate hike cycle in the 2010s, the Fed waited about two years before reducing its balance sheet.
Sean asks if this ‘Fed pivot’ to the more hawkish policy will be problematic in 2022. I think the market and economy can absorb tighter policy for two reasons.
First, it is also important to acknowledge current Fed policy is extraordinarily accommodative. In other words, even if the Fed follows through with ending QE, raising rates three or four times in 2022, and they start shrinking their $8.76 trillion balance sheet over the year, they would still end the year with a very accommodative monetary policy stance, by historical standards. The Fed’s actions in 2022 may be better described as ‘becoming less accommodative’ versus engaging in monetary tightening, in my view.
Second, during the last cycle, many readers may remember that the Fed started raising interest rates in December 2015, pushing the fed funds rate from 0.5% in December 2015 up to 2.5% in December 2018.3 I am not saying there was no market volatility in the wake of the monetary tightening – there was. But for long-term investors, short-term market volatility should not be much of a factor. Market returns matter over years and decades, not weeks and months.
As you can see from the chart below, Fed tightening caused a few blips and pullbacks during the last bull market, but QE tapers and rate hikes were not powerful enough to prevent the market from pushing higher over time. The bull market cycle continued for years after rate hikes commenced.
The S&P 500 During the Previous Monetary Tightening Cycle
So, while I do think a shift in Fed policy and interest rate increases could result in heightened volatility in 2022, I do not necessarily view their approach as ‘problematic.’ I still expect economic and earnings growth to continue apace in the new year, albeit at more modest paces than last year.
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Disclosure
2 ZIM may amend or rescind the “Retirement Made Easy” guide for any reason and at ZIM’s discretion.
3 The Balance. January 6, 2022. https://www.thebalance.com/fed-funds-rate-history-highs-lows-3306135
4 Fred Economic Data. January 7, 2022. https://fred.stlouisfed.org/series/SP500
5 ZIM may amend or rescind the “Retirement Made Easy” guide for any reason and at ZIM’s discretion.
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