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.