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The Fed Continues to Tighten, and Markets Stagger

Published on: Nov 01 2022

Do you believe Federal Reserve officials will do what they say?

If you do, expect interest rates to rise higher and economic growth to continue declining. Fed officials say they’re determined to restore their anti-inflation credibility and bring the 12-month inflation rate much closer to their 2% to 2.5% target. The Fed leaders admit accomplishing this will result in more economic pain, perhaps a recession. Investment markets indicate most investors still don’t believe this. Mar- kets indicate investors expect inflation will decline quickly, and the Fed will be reducing rates soon.

That’s not surprising, because we’re in an economic and market environ- ment that’s new to many investors. It is a very different environment from what many investors experienced in the last 10 or 20 years. The Fed no longer is supporting prices of stocks and other assets. Instead, it is deliberately trying to reduce asset prices and make cash an attractive investment.

Though many believe temporary supply issues are causing inflation, the inflation of 2022 is driven primarily by high demand, the result of the stimu- lus policies of 2020-2021. Inflation has become embedded in much of the econ- omy, and curtailing inflation will take time and significant restraint by the Fed. Investors also ought to be concerned about what the next crisis (or crises) will be and when it will occur. This year, interest rates rose at one of the fastest paces ever.

When monetary policy is tightened quickly and interest rates rise sharply, bad things tend to hap- pen. U.K. pension funds were in turmoil in September because of the changes. In early October, rumors circulated that an- other European banking cri- sis was developing because of the pension problems. A characteristic of finan- cial crises is that few people anticipate them. They catch us by surprise and cause market disruptions.

One reason many investors expect an easy transition to lower inflation is there’s little knowledge of the lags that occur when the Fed changes monetary policy. Financial assets feel the effects first. We saw that from the outset of 2022, with stock and bond prices falling sharply. The effects are reflected next in the economy, especially the interest-rate sensitive sectors such as housing. We started to see those effects during the summer, and they should spread.

But they’ll spread slowly. The economic effects have an additional impact on stocks after investors assess how much the economy will slow. Only after economic growth and asset prices fall does inflation finally descend toward the Fed’s target. Financial assets are down significantly. In fact, the first three quarters of 2022 were the worst period ever for stocks and bonds by some measures. (See my Bob’s Journal of October 6.) But it’s unlikely we’ve seen the worst yet because this year’s inflation is per- sistent. Investment markets and the economy will continue to decelerate for a while.

The Fed was behind the inflation curve in 2021 and now has to catch up to where it should have been, and then some. In addition, there are long-term changes in the global economy that put upward pressure on inflation. They include green energy policies, less glo- balization, the aging and shrinking work force, and more. The Fed can’t afford to pause or back down. If it does, we’ll be in an extended period of stagflation characterized by weak economic growth and high infla- tion, as we were in the 1970s. Investors need protection in their port- folios for a while yet.

Avoid traditional bonds. Instead, look to principal protect- ed assets such as certificates of deposit (CDs) and annuities. Be sure your portfolio has full diversi- fication, holding more than stocks and bonds. Reduce risk and be sure all your assets have margins of safety. The ability to sell short stocks and other invest- ments, which several of our recom- mended funds have, is a valuable tool.

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