A new Fed tightening cycle has begun, and people are furiously debating how it will evolve in the months ahead. The charts below give a sense of just how easy monetary policy had become and what might be in store as the training wheels come off the US economy.

The top chart plots the shadow policy rate and inflation.1 The difference between the two data series is the shadow policy rate in real terms (shown in the bottom chart). The most recent point is the lowest level on record by quite a stretch. Monetary policy has arguably never before been so easy in real terms, and it comes at a time when inflation is worrisomely high.

Shadow Policy Rate & Inflation
Shadow Policy Rate & Inflation from December 1960 to November 2021

Shadow Policy Rate & Inflation from December 1960 to November 2021
Source: Loomis Sayles, Bloomberg as of January 31, 2022

There are several implications:

  1. The mismatch between inflation and policy shows the Fed is behind the curve and needs to move with some speed and determination. But the Fed has a long way to go before monetary policy would be deemed neutral, never mind restrictive.
  2. The market is expecting the Fed to remove a significant amount of accommodation in short order, but policy will still end the year in a very easy position. I see the real shadow rate going from its current low of about -6.5% to roughly -1.25% by the end of this year. That’s a back-of-the-envelope estimate based on three main drivers: the tapering of quantitative easing, the 175 basis points in rate hikes currently priced into the market, and the widely held belief that inflation should trend toward 3.0% as pandemic bottlenecks ease. It’s a big adjustment, but Fed policy will still be quite accommodative.
  3. It’s unlikely that the Fed’s actions will drive the economy into a ditch over the near term. A healthy consumer, strong corporate fundamentals and a well-capitalized banking system should continue to be a tailwind to economic activity even in the face of initial Fed tightening. Economic growth will likely stay above its long-term trend in 2022, especially if the pandemic eases.
  4. However, the financial markets are not the real economy. Financial conditions are on track to tighten a lot in a relatively short period of time. High valuations and low yields leave a lot of financial assets vulnerable to even a small jump in discount rates. This adjustment is already under way, with longer-duration assets in the fixed income and equity markets bearing the brunt of the pain.
  5. As an investor, your perspective on the value in everything from US Treasurys to credit to equities is linked to where you see inflation going from here. If inflation trends look promising, then solid underlying fundamentals and a still-accommodative Fed should make for a relatively shallow, short-lived correction. If inflation does not show signs of cooling below 3.0% as 2022 progresses, then the Fed might have a lot more wood to chop. The market currently pegs the terminal fed funds policy rate at 2.0%. That seems too low if inflation is still a major concern. It’s more likely the Fed would lean into inflation harder with more rate hikes and more aggressive quantitative tightening than what's currently expected. That would be painful for financial assets and, worst case, it could risk tipping the cycle into a full-blown downturn.
Markets Look Fairly Sanguine on Inflation. Will They Be Right?
It has been a long time since hotter inflation has become such a wild card for financial markets, but investors appear to be rather sanguine judging from what is priced into the forward curve. Inflation seems very likely to roll over as the pandemic effects ease. But there are worrisome signs that underlying inflation may be trending uncomfortably above the Fed’s 2% target. A particularly thorny problem would be if wages are rising from a structural shift to tight labor conditions, and this will be an area to watch carefully. If that’s the case, the next few years will likely be very bumpy for the rates markets and the risk trade. As rates rise and volatility returns, I think active credit selection will be vital.
1 The shadow policy rate helps measure financial conditions once the fed funds policy rate reaches zero.

Quantitative easing is a monetary policy whereby a central bank purchases predetermined amounts of government bonds or other financial assets in order to inject money into the economy to expand economic activity.

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