Manager Thoughts on the Fed and Inflation

Last week, markets were spooked by comments by the Federal Open Market Committee indicating that they are likely to raise the target rate earlier than previously expected. Back in March, the Fed’s guidance was that rates would be held close to or at zero through the end of 2023. The recent rise in inflationary pressures and concerns about keeping rates too low for too long has forced the committee to reconsider their approach; they now project that the benchmark rate will increase by the end of 2023.

This is significant for markets for a few reasons. First, higher interest rates act as “brakes” on an overheating economy. Higher rates equate to more expensive capital, meaning it becomes harder for businesses and individuals to get access to money to fund operations and investment. This should directly result in dampening economic activity and cooling inflation. Secondly, and maybe more importantly, it shows that the Fed underestimated the amount of expected inflation this year and they gave guidance that there is upward pressure on inflation in their most recent meeting. Markets were obviously concerned by this as higher inflation means higher costs for goods and services. If inflation is not contained, this can create a positive feedback loop where higher prices beget even higher prices for these goods and services. This would require extraordinary measures to combat if left uncontrolled (think: early 1980s) and could result in serious growth headwinds for the U.S. and global economy.

Source: iStock 2021

That being said, the Fed and many market analysts still expect this rise in inflation to be transitory. The global economy is reopening from the serious disruptions caused by Covid-19 and supply chain bottlenecks are arguably inevitable as the recovery continues to accelerate over the next several months. Additionally, during the pandemic, inflation numbers were muted as economic activity contracted. This means the inflation numbers we are seeing this year are amplified from being compared to the low levels seen last year. It is our feeling that as supply chain disruptions are resolved and the economy normalizes after this period of rapid growth, inflation figures will likely stabilize. Markets tend to react strongly to these types of developments but, as always, we urge our clients to pull back the lens and look at the big picture. Even if we do see another bout of volatility, our core beliefs still stand: it is very difficult to time the market, a diversified portfolio helps to dampen volatility and achieve client goals, and it is most important to maintain a long-term time horizon when investing.

Disclaimer: Economic and market forecasts presented herein reflect our judgment as of the date of this presentation and are subject to change without notice. These forecasts are subject to high levels of uncertainty that may affect actual performance. Accordingly, these forecasts should be viewed as merely representative of a broad range of possible outcomes. These forecasts are estimated, based on assumptions, and are subject to significant revision and may change materially as economic and market conditions change. These forecasts do not take into account the specific investment objectives, restrictions, tax and financial situation or other needs of any specific client.