Total Return Outlook: We Have Liftoff!

Beyond the physical toll, the pandemic continued to roil global economies for a second year. In 2021, it was disruption of the supply chain, which dealt the most difficult blow, as inflation began to surge – especially in the United States. In a sense, the Fed got what it sought in 2020 – inflation above target for some period, but never did they expect to see headline CPI more than triple their long-term target of 2%.

Most of 2021 was spent debating the persistence of inflation – transitory was a word that was bandied about for many months, until late in the year when higher and higher inflation readings quelled the notion that inflation was purely a passing concern.

It leaves the Fed in a very precarious position as we enter 2022. On the one hand, easy monetary policy has spurred economic growth with a recovery in the labor market and risk assets at lofty valuations. On the other, the more persistent forms of inflation – specifically wage and rent inflation – are less likely to abate with a simple flip of the QE-switch. This has become a clear case of “be careful what you wish for” for Chairman Powell and team.

However, the dual-pronged approach to quantitative easing leaves the Fed a fairly elegant solution for removing accommodation beyond the crude “fed funds target rate” lever. That the Fed has openly discussed a timeline for reducing its balance sheet – and discussed this while still purchasing assets (albeit at a slower rate) shows at least an awareness of the need to act quickly and forcefully should inflation remain well beyond their comfort zone.

To recap the last two years, quantitative easing has successfully bolstered risk assets while artificially depressing yields. In particular, QE depressed yields on longer maturity Treasuries that were purchased by the Fed. Quantitative tightening will unavoidably have the opposite, if not equal, effect. But how and when it is implemented is key, and bringing balance sheet reduction into the equation makes for better outcomes. We see three potential scenarios:

  • To counteract an overheating economy, the Fed can raise the target fed funds rate, as usual.
  • To counteract inflation, the Fed can reduce its balance sheet more aggressively – which would effectively raise longer maturity rates while maintaining some “dry powder” for raising shorter rates more slowly.
  • To counteract both an overheating economy and inflation, they can begin with hikes to lift the target rate off the zero bound, but ultimately use both levers to effect the outcome that provides the softest landing for the economy.