How Aggressive Is the Fed’s New Policy Stance?

The Federal Reserve last week announced an accelerated exit from its asset-buying program, putting policymakers on track to conclude tapering in March 2022, and signaled its willingness to raise interest rates at a faster clip than expexcted, penciling in as many as three hikes for 2022.

Though some view these moves as one of the central bank’s most hawkish policy pivots in years, is the Fed as hawkish as it seems? Indeed, some investors seem skeptical that anything has really changed: Equity markets cheered the latest announcement, while the bond market’s reaction was muted.

In our view, the Fed’s recent signal that it is “on the inflation case” appears prudent but dovish. Its guidance, for example, trails market pricing and the central bank’s own expectations for economic growth and inflation, which foresee real GDP of more than 3.5% and annual inflation above 2.5% for the next few years. At the same time, the Fed has called for six rate increases in this cycle, which would take the fed funds rate to only between 1.5% and 1.75%.

These projections imply a world of lower-for-longer interest rates and persistent negative real, or inflation-adjusted, rates, despite a return to sustained above-average economic growth.

The Fed’s approach also comes amidst what we believe are persistent inflationary pressures. While the central bank has focused primarily on supply-chain imbalances as the source of inflation (and certainly they are impacting the prices of everything from semiconductors to auto parts to construction materials), supply-chain issues alone do not explain current levels of inflation. Consider these three factors as well: 

• Rising rents: In 2021, home values appreciated about 19%, based on the Case-Shiller index. Look for rents—which tend to lag home prices by roughly 12 months—to rise as well next year, assuming labor markets remain on the mend.

• Resilient energy prices: Energy prices are also poised to remain resilient, with investment in fossil fuels and high-carbon sources having lagged for the past few years. China’s economic slowdown helped check energy-price increases in 2021, but we expect that trend to reverse in 2022 as Beijing’s stimulus measures take hold and overall global economic growth picks up.

• Higher wages: A recent Employment Cost Index reading of 3.8% was well ahead of estimates and the highest since 2004. Such pressures are also apparent in small-business survey data that indicate labor shortages are leading to higher wages.

In its latest moves, the Fed may be looking to extend the business cycle and ensure maximum employment. But this approach risks letting asset markets run even hotter and leaving genuine inflation-fighting to another day. We expect real 10-year Treasury rates to rise, which could threaten the valuation multiples of technology-heavy stock indices.

The good news, as we have noted, is that about 80% of the U.S. stock market has already re-priced to reflect these rate dynamics. That means there is ample opportunity for active stock-picking among securities that are well off their prior highs. Consider taking profits from defensive growth stocks and long-duration assets and adding exposure to quality cyclicals with undervalued cashflows.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Dec 20, 2021, “Retiring the T-Word?” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.