Macro and Market

Fed Tackles Mounting Inflation With Belated Rate Hike

Rising rates and volatility emphasize the need for portfolio diversification and downside protection.
By Charles Tan
MAR 16 | 2022
Close up of  United States Federal Reserve seal.

After misreading the inflation landscape last year, the Federal Reserve (Fed) now faces the difficult task of slowing inflation without stalling growth while war rages in Ukraine.

We believe taming inflation will require the Fed to take much more aggressive action.

In this challenging market, we believe investing across multiple asset classes and sectors with a focus on downside protection is a prudent approach.

For the first time in more than three years, the Fed has raised short-term interest rates. The quarter-point hike still leaves the federal funds rate target at a historically low level of 0.25% to 0.5%. But it’s likely only the first of several rate hikes designed to tame soaring inflation and normalize interest rates.

However, inflation isn’t the only challenge facing central banks. The war in Ukraine, record gas and commodities prices, supply chain disruptions and slowing growth complicate the Fed’s task.

Here are some key issues that today’s historic and complex backdrop pose and what they could mean for investors.

Q. With U.S. inflation at a 40-year high, is a quarter-point rate hike enough?

A. Clearly not. I think a 50 basis points (bps) hike would better signal the Fed’s recognition of the severity of the inflation challenge. A larger rate increase would also demonstrate the Fed’s inflation-fighting mettle.

In our view, the central bank waited too long to hike interest rates. The Fed misread the inflationary landscape in 2021, initially thinking rising prices would be “transitory.” But, as recent data have shown, inflation has only surged, climbing to levels we haven’t seen since the 1980s.

Now, with annual headline inflation at nearly 8%, economic growth slowing, a war in Ukraine, and soaring commodity prices, the Fed faces a difficult mission. Policymakers need to rein in inflation, but they fear raising interest rates puts economic growth at risk.

Ultimately, we believe taming inflation will require the Fed to take much more aggressive action. This may include making potentially larger-than-typical rate increases and reducing its $9 trillion balance sheet.

Markets are used to the Fed adjusting rates in 25-bps increments, particularly in rising-rate cycles. The Fed hasn’t lifted rates by 50 bps since May 2000. But again, we haven’t had inflation this high in 40 years.

Q. The last time inflation was nearly 8% (early 1982), the fed funds rate was approximately 14%. Do you think rates will rise to double-digit levels this time?

A. I believe such a scenario remains highly unlikely. Our economy has much higher debt leverage today than in the 1970s and 1980s. Because of this, I would expect a sharp economic downturn well before rates get to double digits, forcing the Fed to reverse course.

On the other hand, the financial markets currently expect the federal funds rate target to peak at only 2%. This may prove too low if inflation turns out to be enduring and more structural.

Q. Do you expect a significant slowdown in growth?

A. We’re already seeing signs that growth has slowed dramatically in the first quarter, perhaps as low as 1.2% (annual rate) in the U.S.{sup}1{/sup} Following Russia’s invasion of Ukraine, the European Central Bank (ECB) cut in half its first-quarter growth forecast to 0.2%.{sup}2{/sup} And before the invasion, the Bank of England already had forecasted first-quarter gross domestic product to be flat.{sup}3{/sup}

We think today’s unusual, complex environment leaves the Fed—and other central banks—with two options:

  1. Policymakers can keep rates unusually low to promote growth, but inflation is likely to continue soaring.

  2. Policymakers can embark on an extended campaign of tightening financial conditions to tame inflation, but the economy may slow, stall or even contract.

In our view, the Fed will stick with option 2. It appears policymakers have concluded soaring inflation is more worrisome than a slowdown in growth.

Q. Given this view, is the U.S. economy headed toward a period of stagflation?

A. Stagflation is not yet our central scenario, but the risk is rising. A relic of the 1970s, stagflation occurs when inflation is high and economic growth is stagnant. Like the 1970s, oil prices are soaring, inflation remains elevated and economic growth is slowing. But unlike the 1970s, today’s labor market is strong, and although the economy is slowing, we still expect it to expand over the next 12 months.

We believe stagflation is a more likely outcome in Europe.

Growth outlooks throughout the region have plummeted amid soaring energy prices. The energy sector has a huge impact on the inflation rate in Europe. And as an added challenge, Russia is the leading energy supplier to the region.

Record inflation and growing stagflation concerns recently prompted the dovish ECB to take a surprising turn. Policymakers now plan to end their bond-buying program in the third quarter rather than the fourth, and they may raise rates later in the year.

The Bank of England already has lifted interest rates twice, as the country deals with its highest inflation rate in 30 years. And it’s likely U.K. policymakers will raise rates again when they meet this week. Elsewhere, the Bank of Canada increased its key lending rate in early March, marking its first rate hike since October 2018.

Q. Other factors over which the Fed has no control—broad supply/demand imbalances, skyrocketing oil prices, rising housing and food costs—are also pushing inflation higher. Will these influences overwhelm the effects of the Fed’s tightening?

A. The current episode of rising inflation is a result of several years of excessively loose financial conditions combined with recent supply shocks. While the COVID pandemic initially triggered the supply shocks, geopolitical tensions are now further aggravating the situation.

Indeed, the inflation backdrop is complex and intertwined with short-term and structural dynamics, some of which are clearly outside the Fed’s control. As such, the Fed’s tightening measures, while necessary, may be insufficient to bring down inflation by themselves.

Therefore, we believe inflation could stay much higher than the Fed’s 2% target for an extended period. And this could pose a serious risk to the economy and financial markets.

Q. When do you expect inflation to ease?

A. Russia’s invasion of Ukraine has introduced a new and complicated dynamic for global markets and inflation. We expect the conflict to further disrupt supply chains and keep prices elevated for a variety of goods.

Our best-case scenario calls for inflation to start moderating later this year. But we don’t expect a rapid or significant decline. In our view, inflation will remain well above pre-pandemic levels until:

  • Supply dynamics improve in the energy commodities sectors, labor markets and manufacturing.

  • Demand trends slow down or contract.

  • Real rates (rates adjusted for inflation) turn positive.

In my view, we won’t see these preconditions emerge for quite some time.

Q. With rates on the rise and inflation high, should investors still hold bonds?

A. Despite the rate backdrop, we still believe bonds have an important place in diversified portfolios. While periods of rising rates and inflation can be challenging for bond investors, it’s important to remember why you own bonds in the first place. Bonds have the potential to provide a steady stream of income and may help limit the effects of stock market volatility.

Rising rates and higher inflation tend to pressure longer-maturity Treasuries and other high-quality bonds. But shorter-duration bonds typically have less price sensitivity to rising rates. For more context, please see “How Bond Investors Can Combat Rising Interest Rates, Higher Inflation.”

Additionally, floating-rate securities, such as bank loans, floating-rate corporate bondscollateralized loan obligations and others generally have little exposure to interest rate risks. They also typically offer more attractive yields than government securities, but with varying degrees of credit risks. Investors need to carefully manage those risks.

Treasury inflation-protected securities (TIPS) offer an alternative for investors concerned about inflation. The value of TIPS adjusts along with inflation.

As inflation rises, the principal value of the security increases, creating a steadily growing stream of interest payments. At maturity, the TIPS owner receives the original principal value plus the sum of all the inflation adjustments. Of course, in periods of broad price declines, the opposite occurs and the value of TIPS declines.

Overall, bonds may decline in value during the early months of a rate-hike cycle. However, as interest rates increase, investors can reinvest the proceeds from coupon payments and maturing bonds at higher interest rates. Over time, this may improve returns.

In these challenging markets, an actively managed bond portfolio with shorter-duration and carefully selected floating-rate securities may enhance returns and offer downside protection.

Q. What do higher rates mean for stocks?

A. Higher interest rates can create challenges for stock investors, too. They raise interest expenses for companies that rely on debt financing, and they increase the cost of borrowing to fund new projects or expansion.

As my colleagues on the equity side have observed, rising interest rates generally present a greater obstacle for growth stocks than value stocks. Higher rates increase the appeal of current income, including bond payouts and stock dividends. At the same time, though, higher rates decrease the value of future cash flows. This is key, our equity team concludes because investors mostly look to future cash flows when valuing growth stocks.

Some value-oriented stocks, such as those in the banking sector, may benefit from rate hikes, according to our equity managers. Fed rate hikes typically push consumer loan and mortgage rates higher. For banks, this may mean increased revenue.

Our stock managers also note that higher rates often increase the appeal of dividend-paying stocks. While issuers of growth stocks often hang onto their cash to reinvest in the business, dividend-focused companies take a different approach. For example, utility companies and real estate investment trusts have routinely paid out large portions of their cashflows to shareholders.

Q. Will the Fed’s action affect mortgage rates?

A. The Fed doesn’t set mortgage rates, but its decisions about rates can indirectly affect mortgage rates and directly affect other rates. When the Fed hikes the federal funds rate target, rates on credit cards, adjustable-rate mortgages and other shorter-term loans generally rise. On a positive note, interest rates on savings, CD and money market accounts also go up.

Conventional fixed-rate mortgages tend to track the 10-year U.S. Treasury note more than the federal funds rate. Fed action doesn’t directly influence the 10-year Treasury yield, but it usually has an impact.

The Fed typically raises rates to slow an overheating economy or, as it’s doing today, to temper inflation. Rising inflation pushes longer-maturity Treasury yields higher, which causes mortgage rates to rise. This is a big reason why mortgage rates started heading higher late last year.

The Fed has a more direct influence on mortgage rates when it’s buying or selling bonds. In times of financial stress, such as the start of the pandemic, the Fed has purchased bonds to support market stability. This buying, which included mortgage-backed bonds and Treasuries, helped push mortgage rates to record lows.

The Fed stopped buying bonds earlier this month. And policymakers have indicated they will start reducing the Fed’s bond portfolio later this year. These steps will likely cause Treasury yields and mortgage rates to climb higher.

Q. How should investors respond to the current market environment?

A. Although the Fed’s rate hike was no surprise, it came amid extraordinary domestic and global circumstances. We’re facing an historic backdrop of war, soaring consumer prices, broken supply chains, rising interest rates and slowing economic growth. And while this combination of factors is unusual, the resulting market volatility is not.

As always, we encourage investors to remain disciplined and avoid reacting to short-term market swings. In our view, investing across multiple asset classes and sectors with a focus on downside protection is a prudent approach in the current market environment.

Additionally, it’s important to remember that market dislocations often create opportunities. We suggest investing with experienced professionals who have the insights, conviction and discipline to recognize and potentially capitalize on attractive opportunities when they’re significantly undervalued.

Author
Charles Tan
Charles Tan

Co-Chief Investment Officer — Global Fixed Income

Senior Vice President

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Federal Reserve Bank of Atlanta, “GDP Now,” March 16, 2022.

European Central Bank, “ECB Staff Macroeconomic Projections for the Euro Area,” March 2, 2022.

Bank of England, “Monetary Policy Report,” February 2022.

Generally, as interest rates rise, the value of the securities held in the fund will decline. The opposite is true when interest rates decline.

Diversification does not assure a profit nor does it protect against loss of principal.

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.