Fed Policy Changes Cause Markets and the Economy to React

Will the Federal Reserve and most investors be very wrong two years in a row? Market prices, especially futures prices, indicate most investors join Fed officials in believing the Fed won’t have to do much to dampen inflation and return economic growth to pre-pandemic levels.

They also expect high profit margins to continue. They were wrong about inflation and growth a year ago. As inflation began rising in 2021, most believed it was transitory and due to temporary imbalances.

They were forced to modify that view as inflation persisted and rose to multi-decade highs, inflicting widespread pain. Now, markets indicate interest rates won’t have to rise much to curtail inflation. But as I’ve said before, recent trends in growth and inflation likely are self-sustaining.

The fiscal and monetary stimulus of 2020 and 2021 enhanced the balance sheets and incomes of many households and businesses. This led to a surge in demand for goods and services businesses can’t meet. The surge in demand, coupled with a shortage of available workers, is causing the largest increases in wages and salaries in decades.

The higher incomes make it likely the demand will continue even as stimulus fades. The rate of inflation will decline somewhat as the more extreme supply and demand imbalances fade. But in most of the economy, supply won’t be able to meet demand for some time. The bottom line is the forces that kept inflation low since the early 1980s are fading. In time, the Fed will have to take stronger measures than anticipated by investors and Fed officials.

Even the Fed’s slow, mild change in policy is altering markets. Interest rates are rising, generating losses in bonds and other interest-sensitive investments. Also, as I’ve warned for a while, the stocks that fared best in recent years are struggling as policies change. The “pandemic-economy stocks” and meme stocks that were hot early in the COVID-19 crisis tumbled by the end of 2021.

In late 2021 and early 2022, the NASDAQ 100 lagged other indexes. The market leaders of recent years face more headwinds than a change in monetary policy. Instead of accommodating them, governments around the world now are targeting the leading companies with higher taxes, antitrust enforcement and other restrictions.

Rapidly rising wages also are an obstacle to businesses used to decades of modest compensation increases. Another headwind for big technology stocks and U.S. stocks in general is that the sector that led global markets for 10 years almost always lags over the next 10 years.

A big issue for stock investors is whether the damage from all these changes, especially the new Fed policy, will be restricted to the highest-flying stocks or spread across the markets. China is also important to the global economy and markets. In 2021, China deliberately reduced growth to make significant changes in its markets and economy. China now needs stimulus to restore its growth rate to 5% or more, and it has announced new stimulus for 2022. But will it be enough?

If China successfully increases growth, that will boost a lot of other economies and add more support to commodity prices. But China’s heavy-handed measures in 2021 could continue to weigh on its economy in 2022. That would have widespread negative effects. Investment returns for a year depend on how events unfold compared to the expectations already priced into the markets.

In early 2022, market pricing indicates investors expect inflation to fall after modest interest rate increases that won’t substantially reduce eco-nomic growth. Investors are looking backward, expecting the next year to closely resemble the pre-pandemic period. A better approach is to expect surprises, be sure all investments have a margin of safety, and be broadly diversified.