Volatility and Fear
Post from First Trust Economics Blog
Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist
Dec. 6th, 2021
At the close on Friday, the NASDAQ Composite Index
was down 6.1% and the S&P 500 was down 3.5%, from their
recent all-time record highs. The 10-year Treasury yield,
which was 1.67% as recently as the week of Thanksgiving,
was yielding 1.35% at the close on Friday. Oil prices have
fallen about 22% from their highs and Bitcoin was down about
28% over this past weekend.
Some investors are worried about the Omicron variant of
COVID-19, and maybe further variants to come. But many
are concerned about the Federal Reserve speeding-up its pace
of tapering quantitative easing, which could set the stage for
interest rate hikes in 2022. Meanwhile, the odds of passing
President Biden’s signature fiscal plan – the so-called Build
Back Better proposal – appear to be no better than 50%, down
significantly from earlier this year.
What this reminds us of is the “stop-go” Keynesianism
of the 1970s, where policymakers would whipsaw between
goosing the economy through loose money and extra
government spending, then battling the ensuing inflation by
tightening monetary policy, slowing the growth of spending,
or even by raising taxes. This ping-pong policymaking was
not healthy for the stock market: the S&P 500 increased at a
1.6% annual rate in the 1970s as consumer prices rose 7.4%.
In recent weeks, the stock market has decided the
economic pain associated with an eventual tightening of fiscal
and monetary policy is more likely to come sooner rather than
later. Investors realize the budget deficit in the year ahead is
likely to be much smaller than the past couple of years, which
will be good for the long-run but could be an economic
headwind in the near future.
Meanwhile, the Fed meets next week and recent
testimony by Fed Chairman Jerome Powell indicates it will
likely hasten the pace of tapering. One theory is that the Fed
could finish tapering as early as March next year. That’s
consistent with the futures market for federal funds, which
appears to be pricing in two or three rate hikes in 2022
(assuming the rate hikes are 25 basis points each).
We think taking the economic pain earlier rather than
later is the better option. The next report on consumer prices
arrives on Friday and we are estimating an increase of 0.7%
in November. If we’re right, that would mean consumer
prices are up 6.8% from a year ago, the largest increase for
any twelve months since the early 1980s.
The longer the Fed waits to address this, the harder it will
be to stop. In the early 1980s, Paul Volcker ended up pushing
the federal funds rate to nearly 20%, which caused a brutal set
of recessions. Some tightening now, versus more tightening
later, would signal wisdom in managing monetary policy.
We also think the economy could handle both a faster
taper and earlier rate hikes. Remember, even when it’s
tapering, the Fed is still expanding its balance sheet, it’s just
doing so at a slower rate. Meanwhile, with inflation
approaching 7%, the “real” (inflation-adjusted) federal funds
rate is lower than it ever was in the 1970s.
But mark us down as skeptical about two or three rate
hikes in 2022. Policymakers and politicians may be willing,
but the flesh is weak. After the last time the Fed finished a
tapering operation, back in 2014, it raised rates only when the
10-year Treasury yield was above 2.00%, not below. It’s hard
seeing the Fed getting aggressive with rates with the 10-year
yield south of 2.00% and, right now, we’re at about 1.4%.
Maybe the Fed will raise once; two or three times seems like
a stretch, even if the economy could handle it and inflation
suggests more rate hikes are needed.
Sooner or later, though, the US will have to pay a price
for COVID era looseness in both money and fiscal policy. For
now, we’re betting more of the pain comes after 2022.