The Fed’s interest rates dilemma: how their decision will impact investors

Policymakers’ attention is increasingly turning to the longer-term consequences of unprecedented levels of fiscal and monetary stimulus.

The U.S. in particular is facing strong inflationary pressures with rates hitting a three-decade high of 7% in December 2021[1]. It was therefore no great surprise when the Federal Reserve announced in early November it would start to scale back its $120 billion monthly bond-buying program[2].

But interest rates have held steady near zero, although it is now expected that they will rise at some point. Fed Chairman Jerome Powell attempted to explain the decision, or lack thereof, saying “There is still ground to cover to reach maximum employment both in terms of employment and terms of participation.”[3]

The dilemma facing the Fed – and policymakers in general – is whether raising rates to dampen inflation could jeopardize the recovery in the jobs market. And their concern is justified – the U.S. economy added a seasonally adjusted 210,000 jobs in November[4]—a slowdown from an upwardly revised increase of 546,000 in October. Another factor keeping interest rates low is the elevated levels of government, corporate and even household debt, both in the U.S. and around the world. To illustrate, U.S. government debt, which currently stands at over $28 trillion, equating to more than $228,000 per taxpayer, is only expected to keep rising in the foreseeable future.

Further, there are the Biden administration’s fiscal spending plans to consider, including the recently-passed $1.2 trillion infrastructure bill, and a social welfare bill, which if eventually passed in something close to its current form, would cost the U.S taxpayer a further $1.7 trillion. This latest bout of U.S. public spending comes on top of the $5.9 trillion of economic stimulus issued in response to the COVID-19 pandemic.

Central bankers will also be acutely aware that much of the pandemic borrowing has been undertaken by those sectors most vulnerable to economic upheaval. Companies such as cruise operators, entertainment venues, clothing retailers, and other businesses impacted by the pandemic, have taken on enormous debts in order to survive. Many heavily indebted businesses in these sectors, which generate substantial tax revenues and employ vast swaths of the labor market, are only just in the process of reopening and will likely need to continue borrowing at elevated levels for a while yet.

As inflation figures are tallying higher than expected, and with consumer demand recovering and fiscal stimulus ongoing, investors should not ignore the potential for inflation to prove less transitory than previously anticipated.

What does this mean for investors?

A combination of still-low interest rates (even amid potential for increases) and higher inflation than the developed world has grown accustomed to in recent decades would produce a new investment landscape. Low interest rates have been a good backdrop for growth stocks, notably tech stocks, at a time when technological advancements are taking place in various fields from commercial space flight to web 3.0 and the blockchain space. At the same time, higher inflation has historically benefitted value stocks in sectors such as energy, agriculture, mining and precious metals. A persistent change to core macroeconomic variables such as interest rates and inflation could have profound and unpredictable consequences for the structure of the global economy. For instance, fortunes could reverse for Asian and European equities, which have a stronger propensity than their U.S. counterparts to fall within the value category and have consequently lagged their North American peers in performance over the past 20 years.

While in this scenario stock market gains look set to continue, as equities are particularly able to benefit from higher inflation (holding the rate environment constant), the theoretical outlook for bonds – government, corporate and otherwise – is less positive.

Interest rates remaining low may benefit current bondholders by maintaining the prices of these assets, but yields will stagnate compared with the returns available in equity markets. Additionally, the prospect of persistent higher levels of inflation attaches more risk to the asset class. If interest rates are not raised and inflation continues to rise, the real value of most debt instruments will drop. On the other hand, if interest rates do rise, then bond prices will also drop. Bonds have been an integral part of fixed income portfolios for as long as modern portfolio theory has been around, but this new investing landscape could prompt a rethink of fixed income investment strategies.

The Fed must make the perfect judgment call. If it raises rates too soon, it risks stifling the nascent economic recovery. But if too late, inflation could begin to accelerate dangerously quickly. The social and economic impact of the wrong call would be enormous. The world will be watching.

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Important Disclosure:

The opinions referenced above are those of the author as of January 12, 2022. These comments should not be construed as recommendations of any investment strategy or product for a particular investor, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations. Past performance does not guarantee future results.

Sources:

[1] CNBC, “Inflation rises 7% over the past year, highest since 1982”

[2] Financial Times, “Fed to start winding back $120bn-a-month stimulus programme”

[3] Jerome Powell press conference, 3 November 2021

[4] CNBC, “Job creation roars back in October as payrolls rise by 531,000”