To the nameless economists who played down the risk of inflation, 2021 was a year to  forget. This week’s data confirmed that U.S. consumer prices rose 7% last year while core  prices rose by a slightly-less-eye-popping 5.5%. The Fed is shifting its tone.

Brian Nick Chief Investment Strategist 


The patterns in last month’s CPI report were  familiar: Durable goods (+1.2%) were outsized  drivers of price increases. Within that category, used  cars were the biggest outlier, rising 3.5%. Overall, services inflation remained relatively tame at 0.3%, but shelter inflation – which is notoriously difficult  to account for given how many people own their  own homes – has been running hotter than normal. 

Inflation in 2021 owed much to the positive demand  shock from multiple fiscal stimulus measures in the  first half of the year and the ongoing shortage of  semiconductor chips that go into products like cars.  The highest months for inflation occurred in the  second quarter of last year, but Q4 marked a return  to inarguably elevated inflation that is capturing  more than just hiccups in global supply chains.


Until last year, it would not have come as a surprise  to markets that a central bank whose economy had  

just experienced a year of 7% inflation might look to  raise rates (OK, other than the Central Bank of  Turkey). But Fed’s shift in tone has been abrupt, from the “all is well because inflation is transitory”  talk of September 2021 to the “actually inflation is a  severe risk” message Jay Powell delivered in his  confirmation hearing just this week. What’s driving  the Fed’s change of heart? 

  1. Supply chain issues aren’t going away fast  enough, and durable goods prices continue to rise  when the Fed and others likely expected them to  be correcting by now. 
  2. The unemployment rate has dropped really far,  really fast and the recovery in labor force  participation has been disappointing. 

The Fed is worried about a high inflation mentality  settling into the economy. Goods prices are still high  and rising, while sharply increasing wages in some  areas are pressuring profit margins and, potentially, prices. We may be seeing a bit of that in the inflation  numbers. Price increases at restaurants and  personal care stores – jobs that tend to be labor  intensive and offer relatively low wages – accelerated in Q4 despite the expiration of enhanced  unemployment benefits in September.



Inflation won’t go away (quickly), forcing the Fed to act 


Our view coming into 2022 was that the Fed could  and would wait longer to see where inflation settles  before raising rates. But it now appears to be taking  inflation risks much more seriously, with a rate hike  now very much in play as soon as March. Markets  have gotten the message, as well, with fed funds  futures contracts pricing in between three and four hikes from the Fed this year.  

The Fed also appears primed to embark on  quantitative tightening (QT) as soon as the second  half of this year. QT occurs as the Fed allows  maturing securities to roll off its balance sheet  without replacing them, draining liquidity from the  financial system and tightening overall conditions.  

The magnitude of this potential tightening remains  unclear, because the Fed has not said how fast it will  allow securities to roll off or what the terminal size  of its balance sheet should be. We know from the  minutes of the December FOMC meeting that the  process will happen “sooner” and “faster” than it did  in the last cycle, but the total amount of balance  sheet runoff will likely only amount to the  equivalent of about one rate increase a year for as  long as the Fed chooses to do it. 


This change in the Fed’s communication – which  drives the change in our view on rate hikes this year  from zero to three – does not materially change our  outlook for broader markets this year. We still do  not see a scenario in which the Fed’s actions  dramatically tighten financial conditions. This  makes the debate between one hike and three hikes  (or even four) far from life or death for the economy.  

It will matter, however, where and when the Fed  stops hiking in 2023 or 2024. In the last few weeks,

the Fed and the market are increasingly aligned on  those years, with the Fed expecting to remain below  its 2.5% equilibrium estimate at the end of 2024.  

Anything short of that rate would, in the Fed’s eyes,  still been considered accommodative policy. 

It is not just the fed funds market that’s taken notice  of the Fed’s changing posture. Equity markets have  begun 2022 with an abrupt change in leadership  from defensive and higher growth stocks to cyclical  and value names. Energy stocks are off to a roaring  start while financials are benefiting from higher  rates and a slightly steeper yield curve.  

Credit markets are performing well despite the rate  volatility. We know from experience even before the  pandemic that periods of sharply rising rates are  typically followed by better returns on equity and  credit markets. We expect the lurch higher at the  outset of 2022 to prove no exception.  

Our view coming into 2022 was that strong  economic growth and benign disinflation would  propel real interest rates higher and help recent  underperforming segments of the market to  outperform – including the eurozone and U.S. value  stocks. It’s safe to say we did not expect the trade to  work quite this quickly. But we still see scope for it  to continue based on our view that the U.S. Treasury  curve can steepen further, with the 10-year yield  ending near 2.5% for the year. 

The Omicron variant remains a wild card for  economic growth. Countries that attempt to contain  the virus via strict mitigation measures could suffer  economically in the first quarter as Covid waves  ripple through the globe. We do not expect this wave  to be as inflationary in the U.S. since the prior two  were due to lack of fiscal stimulus to U.S.  households. But disruptions to global manufacturers  and supply chains could leave goods prices higher  for longer. 

Omicron and concerns about policy tightening add  to our conviction that 2022 will be “Slower” than  2021 “…but still pretty fast,” and overall that should  benefit investors with diversified portfolios and risk on positioning.

By Stocks Future

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