The FED in 2022, Steady as She Goes

October 11, 2021

Here we go again.  Last Friday the Bureau of Labor Statistics released the September jobs report.  Despite a much lower than expected number of 194,000 new jobs created (the markets were expecting 500,000) analysts keyed in on a 4.6% wage growth and a 0.4% reduction in the unemployment rate.  Pundits were quick to assume this economic news would add to the pressure on the FED to soon reduce its balance sheet and begin raising rates in 2022.  In fact, for the past 3 weeks bond vigilantes have pressed 10-year US interest rates higher in anticipation that the FED would begin its initial “tapering” in Q4 2021.  Fed Funds futures are now pricing a 1% interest rate within 12 months.  A new phase of interest rates may be on our doorstep.

Even the currency markets are thinking rates are headed higher. So far in 2021 the US Dollar Index had increased almost 5%, and almost 2% since mid-September. Over the latter period both the yen and euro have declined -3% and -2% respectively against the dollar.  Currency traders must be thinking our rising interest rates are attractive compared with the negative and near zero-interest rates in other developed nations.  Institutional investors are buying dollars to get yield on their savings. 

The FED knows full well the challenges it faces in engineering a less accommodative, but economically sensitive, interest rate policy and simultaneously reducing in its balance sheet.  Back in the day we referred to this delicate landing as a “soft landing.”  The FED knows raising rates too fast and too soon could stall our interest rate sensitive economy which has been made fragile by the pandemic.  Higher rates could negatively impact consumption, housing, and investment.  30-year mortgages are already inching up above 3%.  The FED also knows that higher rates will impact the servicing of private and public debt.  The FED is also sensitive to US stock market performance.  If rates jump too high it could tug on stock values which have built-in an above average valuation attributed to strong growth and low, expected inflation. 

Finally, the FED is fully aware of the strong correlation in risky assets (like stocks and real estate) and the growth in its balance sheet.  Risky assets have grown in lockstep to the recent financial stimulus and FED balance sheet growth. Many real estate portfolios have been built on an assumption of continued low borrowing costs.  In addition, not only are borrowing costs for investment grade companies at historically low levels, but credit spreads (cost above treasuries) are at a historically low spreads implying limited credit default risk. 

The FED knows full well ultra-low interest rates have been critical to sustaining economic growth. We hope the financial markets appreciate the difficulty in engineering a soft landing without being disruptive to the status quo and market assumptions.  Bon voyage to the ‘USS American Economy’ as its captains seek to keep her “steady as she goes”!

Gary B. Martin