by Shawn Narancich, CFA
Executive Vice President
Powell Pivot
In one of the most anticipated weeks of monetary policymaking in recent memory, the Bank of England became the first major central bank to raise interest rates off the near-zero bound and the U.S. Federal Reserve laid the groundwork for such a move by proclaiming the impending conclusion of its quantitative easing (QE) stimulus program by next March. Headline inflation of nearly 7% and an unemployment rate approaching 4% finally has the Fed’s attention. One view of stocks’ surprising post-Fed decision rally Wednesday is that a faster conclusion of QE and quicker than anticipated lift-off for rate hikes will help contain longer-term inflation expectations, which is of high importance to the Fed and equity investors. As the chart below shows, 3-year forward inflation expectations are elevated, but notably below those shorter term.
Sources: NY Fed Survey of Consumer Expectations, Strategas
A Fait Accompli
Policymakers realize that the longer above-targeted inflation persists today, the more likely consumers will build such rates into their longer-term expectations. The risk is that inflation expectations become unhinged from the Fed’s 2% inflation target, incenting consumers to front-run price increases and embed elevated inflation rates into their wage and salary calculus. Accordingly, the Fed’s communication earlier this week to reverse a policy of monetary accommodation signals the end of its experiment termed flexible average inflation targeting instituted the summer before last.
After observing a pre-COVID inflation rate that routinely undershot its 2% target amid sub-4% unemployment, the Fed could be forgiven for allowing inflation to temporarily overshoot its targeted rate. Nevertheless, surging consumer demand and ongoing supply bottlenecks persist, necessitating a policy pivot.
Threading the Needle
All of which brings forth a key question -- how does the Fed’s stated goal for inflation align with what history says is the best rate of inflation for equities? As the chart below shows, inflation in a range of 2-4% has proven to be optimum regarding the multiple of earnings that investors are willing to pay.
Source: Strategas
As projected at its FOMC meeting this week, the Fed expects inflation as measured by its preferred measure — the Personal Consumption Expenditure Deflator — to halve from 5.3% this year to 2.6% in 2022. If this prediction proves accurate, it bodes well for stock valuations next year.
With legislated tax rate increases expected to be much less impactful than first thought and a strong labor market underpinning economic expansion, we expect corporate earnings to make forward progress in 2022. After outsized profit gains that we anticipate will approach 50% this year, earnings growth and equity returns next year are likely to be much less extraordinary.
Our Takeaways for the Week
Stocks fell as central bankers signaled tighter monetary policy ahead
Heightened market volatility this week foreshadows more of the same next year