Get ready for a larger-than-expected interest rate spike in 2022

As investors assess what is in store for 2022, they should not lose sight of what has transpired over the past two years.

What stands out is that the COVID-19 pandemic is different than any prior global shock in the last 50 years. When it struck in early 2020, the economy suffered its steepest decline on record as businesses and schools were shuttered. But it also rebounded quickly as businesses reopened, and it has since recouped all of the output declines and most job losses. The economy has also experienced the steepest rise in inflation in three decades.

The quick recovery is testimony to the unprecedented fiscal and monetary policy response that occurred, as well as to the resilience of U.S. businesses and the workforce that has been facilitated by the digital economy. 

The vigorous policy response in turn provided cover for investors to add risk to their portfolios. Stock market returns since late March 2020 have exceeded any comparable period in U.S. history with the major indices doubling in value. And there has been no meaningful correction over that period. 

Looking ahead, the investment landscape will likely prove trickier for several reasons. First, the COVID-19 pandemic is proving more difficult to eradicate than many had anticipated. Second, the Fed has signaled it will likely raise interest rates to curb inflation. Third, much of the good economic news has been priced into markets.

Of these, the hardest to forecast is the pandemic. One of the key lessons from the delta variant, however, is that it did not produce lasting damage to the economy because businesses and schools remained open. Accordingly, Federal Reserve Chair Jerome Powell told lawmakers that the economic effect of the omicron variant would not be “remotely comparable” to what occurred at the onset of the pandemic. But it could influence monetary policy if the economy slowed.

The focus of investors currently is on the prospect of Fed tightening to curb inflation. After being in denial earlier, the Fed now recognizes the pickup in inflation this year is not transitory and could persist into 2022 and 2023.

At the December Federal Open Market Committee (FOMC) meeting, the Fed announced it would speed up its tapering of bond purchases to conclude in March 2022, and it increased the projections for the federal funds rate. The median forecast of FOMC members now calls for three rate hikes in both 2022 and 2023, with a terminal rate of 2 percent-2.25 percent by 2024.

The looming issue is whether this gradual glide path of rate increases will be sufficient to bring inflation back to the Fed’s average annual target of 2 percent. 

I am skeptical for several reasons. First, the median projections of Fed members for the coming year call for real GDP growth of 4 percent and the unemployment rate to fall to 3.5 percent, which suggests the economy will be approaching its long-term potential. 

Second, inflation expectations are becoming embedded in wages, which have risen steadily and are now approaching 4 percent.

Third, while supply-chain disruptions may ease as the coronavirus pandemic abates, the housing component of the Consumer Price Index is likely to stay elevated. Finally, fiscal and monetary policies are still accommodative.

Financial markets have taken the news in stride thus far, as the Fed’s forecasts are in line with what investors were anticipating. Bondholders, nonetheless, should realize that even if inflation subsides to the Fed’s 2 percent target in the next few years, they in effect will be accepting negative yields in real terms throughout this period. 

So, why would they do so?

My take is that investors’ expectations about inflation and interest rates have been shaped by the experience following the 2008 Global Financial Crisis, when economic growth and inflation were subdued for a decade. This outcome is consistent with prior bouts of financial crises, as Carmen Reinhart and Kenneth Rogoff spell out in their article “Recovery from Financial Crises.”

By comparison, the coronavirus pandemic is a completely different type of shock that did not inflict lasting damage on the economy and the financial system.  While it has taken a heavy toll on people’s lives and well-being, it has also unleashed unforeseen changes in the way business is conducted and how people go about providing for their livelihood. Throughout the travail, what stands out is that many U.S. companies are highly adaptable and experienced increased productivity while others have seen their businesses disrupted.

As a result of the policy support during the pandemic and the resilience of the American economy, the U.S. stock market has posted outsized returns in the past two years that far exceed other developed markets. To a large extent, the gains this year reflected a strong rebound in corporate profits, with earnings for S&P 500 companies up by 40 percent. Going forward, however, investors should lower their return expectations as the economy and earnings normalize while interest rates rise.

How well the stock market performs will hinge to a large extent on how inflation fares. If it recedes as the Fed expects and interest rate increases are gradual, valuations are likely to remain high. But should inflation prove to be persistent, and the Fed is compelled to accelerate the pace of rate hikes, the stock market would become vulnerable and the bull-run could end. For this reason, I believe caution is warranted.

Nicholas Sargen, Ph.D., is an economic consultant and is affiliated with the University of Virginia’s Darden School of Business. He is the author of “Global Shocks: An Investment Guide to Turbulent Markets.”