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Don’t fear the rate hike  

“No postwar recovery has died of old age—the Federal Reserve has murdered every one of them.”  

– Rudi Dornbusch, MIT Economist 

Early this year, the Federal Reserve increased the federal funds rate, which begins a cycle of multiple rate hikes over the next several months. Just a few short months ago, investors expected two or three hikes in 2022; however, with inflation remaining higher for longer, expectations are now up to eight increases over the next nine months. This tightening cycle has led some prognosticators to start bringing up the “R” word…recession. We do not believe this is in the cards, but as Mr. Dornbusch famously said, the Fed can certainly go too far, resulting in a recession.

Jason Norris

This economic expansion has been unprecedented. It started with a brief-but-deep recession followed by a strong snapback. When the economy came to a stop due to the pandemic, the unprecedented amount of fiscal and monetary stimulus resulted in a shorter-than-average recession during the pandemic. While global economies remained in lockdown, consumers were flush with cash. This led to a massive increase in savings and a major shift in spending from services to goods. The chart highlights the amount of spending for goods and services relative to the recent trend.  

Image provided by Ferguson Wellman

What has happened since March of 2020 and what’s different today? First, stimulus funds and the shift to spending on goods resulted in an excess of over $1 trillion relative to the long-term spending trend. This phenomenon resulted in backups at ports and other supply-chain issues. Too much money chasing too few goods, which is the classic definition of inflation, was the situation we found ourselves in. The service economy was still limited so the demand for goods spiked. With congestion in the supply chain causing too few goods, rising pricing were bound to follow.  

The second factor was the labor market. There was still considerable hesitation for workers to get back into the labor market. We saw early retirements, people staying home due to health and childcare issues, and fiscal benefits lasting for an extended period. This left the economy with strong demand and a labor shortage, creating upward pressure on wages to pull people back into the market. We believe this wage pressure will start to dissipate in the coming months. The chart below shows the labor force and as of March, we are back to where we were before the pandemic.  

Image provided by Ferguson Wellman

This labor trend looks even better in Boise. The month of January saw the largest increase in labor supply in over 30 years. This should slowly help ease the worker shortage the region has been experiencing, which is playing out through fewer postings for open positions on the employment website, Indeed.  

Third, with elevated commodity prices due to the conflict in Ukraine, inflation has remained elevated longer and at a higher level then we, and the Federal Reserve, anticipated. Thus, the Fed must be more aggressive in raising rates.  

Over the last several weeks, we have seen a meaningful pickup in interest rates. The chart below shows the yield curve from January 1 to April 4. Highlighted is the increase in shorter-term rates relative to longer-term. This creates the infamous “inversion” the press has been highlighting of late as “breaking news.” 

Image provided by Ferguson Wellman

Why has an interest-rate inversion been a signal to a recession? When short term interest rates reach levels higher than long-term rates, that is an “inversion.” Historically, this signals that the Federal Reserve has to raise short term rates, but growth will slow, thus long-term rates staying lower. We are of the belief that this inversion will not result in a recession. The pickup in short-term rates is signaling the Federal Reserve hikes; however, the lack of longer-term-rate increases shows that investors believe inflation will come back down and the Federal Reserve may have to cut. We agree with what the bond market is signaling. There has already been some easing of the supply-chain pressures. Gas prices have fallen from their peak and shipping costs are declining.  

For the remainder of 2022, we believe that interest rates will trend higher. However, unlike the current market expectations, we do not think the Fed will hike eight times. Supply chains loosening up will help with “goods” pricing. Labor participation should revert to pre-pandemic levels and start to ease the upward pressure on wages. Inflation may end the year around 4% and we believe it will settle back into a long-term trend of 3% in 2023. We don’t believe interest rates will move high enough to choke off economic growth. With this scenario, the Fed is unlikely to “murder” this recovery.  

What does this outlook mean for investors? Mild inflation is positive for the stock market. Healthy profit growth leads to a higher stock market. In contrast, rising interest rates are a headwind for bonds. As rates rise, bond prices decline. We’ve already seen one of the worst bond market returns this year. But, do brace for higher volatility. During periods of interest rate hikes, market volatility is elevated as investors handicap the effect on rising rates.  

— Jason Norris, a chartered financial analyst, is a principal with Ferguson Wellman Capital Management, which serves individual and institutional clients throughout the West. The company currently manages assets valued at $282 million in Idaho (as of January 1, 2022). This material has been prepared for informational purposes only and should not be viewed as advice or recommendations with respect to asset allocation or any particular investment. 

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