The year 2022 will forever be remembered as the year when the Fed, to combat the highest inflation in four decades, unwound the easy monetary policy of the past 15 years. Between March and December, the Fed raised interest rates seven times for a grand total of 425 basis points — bringing the Fed funds rate to its highest level since 2007.
As if that wasn’t enough, in June, the Fed began a new “quantitative tightening” exercise to shrink its balance sheet, a process that adds further upward pressure to interest rates.
While the Fed’s rate hikes have thus far had little impact on inflation, they’ve undoubtedly had a major impact on global financial markets. Stock and bond markets across the globe finished 2022 in the red. Virtually every major asset class finished down for the year.
One thing seems certain: 2022 was the year sobriety and common sense returned to financial markets. The prices of everything from stocks and bonds to real estate and cryptocurrencies are again re-tethered to interest rates. Consequently, monetary policy — specifically where the Fed lands on interest rates — will ultimately determine the direction of the economy and markets in 2023.
Is the Fed Using a Hammer to Drive a Screw?
As long as the Fed performs modest hikes as expected, there shouldn’t be a major market upheaval. If the Fed enacts more aggressive hikes, it will be detrimental to the economy. Further, the U.S. economy probably doesn’t have the productive capacity to sustain interest rates at current levels, let alone higher interest rates. For a long time, there has been a disconnect between the Fed’s narrative and what the data tells us. The Fed has been responsible for the doubling of mortgage rates, yet there has been little movement on inflation to show for it.
In some ways, their approach seems to stem from a misguided orientation that today’s inflation is caused by demand-side forces. The evidence suggests that what’s been causing inflation has less to do with consumer spending and more to do with COVID-related supply constraints and tight labor markets.
Part of the Fed’s motivation is political. Every Fed board member, at one time or another, has promised Congress they would not hesitate to hike rates to combat inflation. However, there’s nothing the Fed can do to influence supply. If indeed the issue was too much quantitative easing or too much fiscal stimulus, we would have likely seen inflation come down more by now.
Soft Landing or Sustained Recession?
The economy today is now threatened more by recession than inflation. A steeply inverted yield curve, a declining Purchasing Manufacturing Index, the highest mortgage interest rates in 15 years, a strong dollar and slumping overseas growth all suggest a recession. Economists surveyed by Bloomberg forecast a 70% chance of a recession in 2023(opens in new tab). Economic forecasts are notoriously imprecise, but what they lack in precision they typically make up for in directional accuracy.
However, the window for the Fed to achieve a soft landing appears to be narrowing rapidly, given the Fed’s hawkish tone and baffling forecasts that ignore November’s decline in inflation. There is a very real possibility that the Fed overtightens and pushes the economy into an unnecessary recession. But we suspect that they’ll change course on rates before that happens. It’s quite possible the Fed’s overly tight monetary policy is inflicting damage somewhere in the financial system, but the nature of the damage won’t become readily apparent for some time.
A Silver Lining Playbook for a Sensible Market in 2023
One silver lining in 2022 is that it helped re-ground investors in the basics: fundamentals matter, predictions should be taken with a healthy dose of skepticism, and prudent planning prevails in the long run. More speculative asset classes, like cryptocurrencies and growth stocks, saw exceptionally steep losses. Relative outperformance, albeit still negative, was to be found in previously unloved asset classes like dividend-paying stocks, value stocks and low-beta stocks as well as short-duration bonds. Gone are the days of digital assets with no tangible value outperforming solid companies with reliable cash flows. The same could be said for any number of speculative asset classes — growth stocks, SPACs, NFTs, etc.
It’s important to keep in mind that the economy isn’t the market. Likewise, the market isn’t the economy. Predicting the future is both an art and a science. The past 12 months have sadly reminded us that we live in a world of harrowing risks that could derail even the most elegant economic forecasts. The war in Ukraine, mounting tensions across the Taiwan Strait, the rise of a new COVID-variant or even public unrest in Iran could derail the global economy in the year ahead.
