Since the 2008 Great Financial Crisis, we have seen an equity market broadly supported by the action of the Federal Reserve. As the narrative goes, to save the world from a financial Armageddon, the Federal Reserve printed money and reduced interest rates, policies that have been mirrored across the globe.
These measures were supposed to be temporary. However, they have remained in place for over a decade. Ironically, just at the point at which the Federal Reserve was finally getting brave enough to raise rates, the COVID 19 pandemic hit. Unsurprisingly, they reverted to the old playbook, reducing rates even further and flooding the market with so much liquidity that even the architects of the 08 bailouts would blush.
The result of these policies since 2008 has been a significant rise in asset prices. While there was a temporary market crash as the realisation that COVID 19 had become a global pandemic, market confidence was again restored by further central bank intervention.
Where the Federal Reserve leads the rest of the world follows, and their actions have given much-needed credibility to the type of monetary policy that economic students are taught to create a basket economy characterised by hyperinflation and currency devaluation.
Congress has given the Fed two coequal goals for monetary policy: first, maximum employment, and second, stable prices, meaning low, stable inflation. While employment data looks strong in the US, inflation has risen to an alarmingly high level. The inflation rate, as measured by the US Consumer Price Index, reached 7 per cent in December 2021. While this should not necessarily come as a surprise, following the global lockdown policies undertaken to tackle COVID, it is undoubtedly a cause for concern.
The hope remains that this inflationary period will be brief as the global economy starts to open and global supply chain bottlenecks ease as the vaccine rollout provides comfort to policymakers. However, action will need to be taken in the form of rising interest rates. A point that has been enunciated by the Chief of the Federal Reserve, Jerome Powell, in a statement on the 26th of January:
“The committee is of a mind to raise the federal funds rate at the March meeting assuming that the conditions are appropriate for doing so.”
In this statement, Powell is signposting for markets to prepare for a rise in interest rates, a signal for investors to prepare for a rising interest rate environment.
While this should not come as a huge surprise, it is still a statement that has resulted in markets continuing their nervous start to 2022. One may ask, why is market confidence so low when the global economy is beginning to open and get back to pre-Covid levels? The answer is that markets have spent too long relying on the continued support of the Federal Reserve, rather than looking at the underlying value of the companies they have invested in.
In the short term, markets in 2022 will likely remain dominated by interest rate decisions of the Federal Reserve, and while the cloud of a rising interest rate environment may cause problems for short term investors, it should not truly concern those with a long-term investment horizon.
It is an important process for markets to get used to a more normal rate environment, and while this short term volatility should be a process in which short term leveraged investors face some tough times, those investing in a strategy based on time in the market, rather than timing the market should be less concerned by the short term volatility and take comfort that they are holdings investments that will benefit from a prevailing inflationary environment.
Also, some perspective is needed. Interest rates are currently at historical lows. While there may be some short-term volatility as we move towards a more normal interest rate environment, it will be better for the global economy in the long term. And while this may sound counterintuitive, this should be something we celebrate.