If the U.S. economy isn’t as strong as the Fed thinks, higher interest rates will hurt.
By Russ Banham
After the government’s stimulative fiscal and well-aged monetary policy put cash into U.S. consumers’ pockets during the pandemic’s height, U.S. consumers did what they tend to do — they spent the cash.
The sudden surge in pent-up demand collided with an overwhelmed supply chain and labor shortages, causing severe dislocations. The consumer price index (CPI) jumped 7% for the full year in 2021. And some key CPI components soared – energy prices rose 29%; used cars and trucks, 37%; and meats, poultry, fish, and eggs, 12%. Companies’ materials and shipment costs shot up.
When the Federal Reserve, now committed to lowering inflation, starts lifting the federal funds rate, presumably in March, CFOs may wonder about the possible consequences, intended and unintended.
Some economists – and the Fed Open Market Committee (FOMC) itself – are confident the move to raise rates will work and not rock capital markets or the economic recovery.
A strong, growing economy, the stock market’s resilience, and still-low bond yields prove the Fed could be on the right path, said Robert Hartwig, director of the Risk and Uncertainty Management Center at the University of South Carolina.
“Three [or four] successive quarter-point rate hikes by the Fed will tamp down aggregate demand and allow inflation to cool off,” Hartwig said. By 2023, Hartwig predicts a return to “more staid and stable” inflation levels, maybe not the Fed’s long-term policy target of 2% but settling below 3%.
Other economists are not so sure. Despite recent domestic economic strength, including another strong showing for profits in the fourth quarter, “we are in a fragile financial environment in 2022,” said David A. Levy, chairman of The Jerome Levy Forecasting Center. The pent-up consumer demand and government stimulus checks that sparked last year’s economic growth suggests it’s not sustainable, he said. In other words, the economy may not be able to withstand the Fed tightening.
“Not with the deteriorating situation in China, the possibility of more COVID-19 variants, and the sheer uncertainty surrounding the Great Resignation,” said Levy.
In addition, the Fed traditionally has trouble “really fine-tuning the economy and fighting inflation,” producing economic instability and large swings in the stock market, Levy said.
The fact that inflation has been so low for so long (since the 1980s) indicates the Fed may have a hard time finding the right notch on the policy dial, Levy said.
The labor issue
Particularly difficult to control with higher rates will be the rising costs from the unusually tight supply of workers.
“This pandemic, the shortages in truckers, and all these lifestyle changes with people saying they’re not going back into the workforce are causing a wage-price spiral that the Fed won’t be able to [calm],” Levy said.
Many CFOs have already given higher-than-typical workers’ raises for 2022. “People in the `Great Resignation’ don’t want to drive trucks or carry 2-by-4s on construction sites,” said Ernie Goss, a professor of economics at Creighton University. “When these labor costs rise to increase employment, wages in other areas [will] tend to follow suit.”
With omicron still running its course, it will take time for the labor force to catch up with demand. “Mass infections are [still] impacting labor supply as workers call in sick or postpone reentering the workforce,” the Conference Board reported on January 12.
The Conference Board forecasts the core PCE (personal consumption expenditures, the Fed’s preferred gauge) price index will still be elevated in the first quarter of 2022, remaining above 4%.
Of particular interest to CFOs (and bond investors) is whether long-term interest rates will rise as the Fed funds rate does. Long-term rates may remain fairly low for the near term, Goss said.
One reason: the multi-trillion dollar increase in what economists call global “cumulative excess savings” during the pandemic, Goss said. This hoard in U.S. bond holdings reached $2.4 trillion in August 2021, up from $64 billion in March 2020, according to J.P. Morgan Chase. Investors sopped up the November and December auctions in 20-year Treasuries, “despite negative real yields, meaning they’ll get less back than they invested in inflation-adjusted returns,” said Goss.
Low long-term rates for longer may benefit companies looking to invest, but the disparity with short-term rates will eventually push up bond yields, slowly, according to Kiplinger. The 10-year yield will rise to 2.1% or more by the end of 2022 from its current 1.86%, and mortgage rates will increase about 50 basis points, the business forecaster estimated.
As for the risk that the Fed’s adjustment won’t contain dramatic increases in the costs of running a business or a household, Hartwig said it isn’t in the cards. “This is not 1980s stagflation [a combination of high inflation, high unemployment, and stagnant demand], despite growing fears among investors that we are headed in that direction.”
Russ Banham is a Pulitzer-nominated financial journalist and best-selling author.