How Will the Federal Reserve React to Increasing Inflation?

Federal Reserve React to Increasing InflationThe Bureau of Labor Statistic’s Consumer Price Index rose by 8.5 percent year-over-year ending March 2022, leading most economists to agree that inflation is going to be with us for a while. With inflation seeming not to abate, at least in the near term, how will different types of investments react to inflation that is sustained and unknown when it will peak and begin to drop. Looking at a 2004 study from the Federal Reserve, an unexpected 25-basis point rate cut can be expected to see equities appreciate by one percent.

Defining Different Rates

The Federal Open Market Committee (FOMC) sets the federal funds rate – the overnight rate at which banks borrow from each other. This undoubtedly will impact the economy and the domestic and global stock markets. While it can take months, if not more than a year, for a change in interest rates to have a universal impact, the stock markets see the impact sooner. This is opposed to the discount rate, which is the interest rate banks are charged when loans come from regional Federal Reserve Banks – the so called discount window.

One main reason the Fed adjusts the federal funds rate is to shape inflation. When the federal funds rate is raised, it is trying to reduce the money supply available for consumers and businesses. With less money available to circulate throughout the economy, it costs more to borrow money as interest rates rise.

Another important reason to keep an eye on the federal funds rate is due to the fact that the prime interest rate is based largely on the federal funds rate. Whether a mortgage, credit card or other personal or commercial loan, the prime interest rate is an influential factor in these lending vehicles’ interest rates. As the Fed Board of Governors explains, the prime rate is how each individual bank determines its own interest rates. Their unique prime rate is based on the target level of the federal funds rate, which is how much other banks charge them for short-term loans. Once the prime rate is established, it is used as a reference base rate for a multitude of lending products, including personal and commercial loans and credit card lines.

FOMC and Federal Funds Rate Adjustments

As the Federal Reserve increases its discount rate, short-term borrowing costs for financial institutions increase. Financial institutions in-turn are pushed to increase borrowing costs for companies and consumers. Whether it is a credit card or a mortgage, rates increase. The higher the interest rate, the less spending ability the account holder has. The account holder also sees higher bills via the higher interest rates. The higher the bills, the less money they can spend elsewhere, often impacting the economy.

Rising Rates and the Markets

Publicly traded companies can suffer in different ways. A company may bring in less revenue or have higher borrowing costs, cutting into its growth forecast or reducing its profits. Companies also may see lower growth expectations and a decline in future cash flow projections. Assuming no other changes, the stock price will likely fall. Depending on how severe the increase in interest rates, this can impact entire sectors – and depending on how much weight a particular company comprises within an index, an entire index.

Bond Market Dynamics and Interest Rate Fluctuations

Compared to corporate bonds, where bondholders are first in line to be paid if a company goes bankrupt, government securities, such as Treasury bills and bonds, are viewed as more likely to pay their investors back even in more challenging financial circumstances. This is because, according to the U.S. Securities and Exchange Commission, they are backed by the full faith and credit of the U.S. government.

As the Financial Industry Regulatory Authority (FINRA) gives an example, interest rates have a noticeable impact on bonds. Say a bond is sold for X and matures in Y years down the road with a Z percent coupon at par value. Twelve months later, interest rates have risen and another of the same type and amount of bond is issued at the same par value but is issued with a one or two percent higher coupon rate. Based on these two different bonds’ characteristics, the original bond is less attractive on the open market. If the original bondholder wants to sell a bond issued a year ago, he will have to sell for less than face value due to the more attractive interest rate of the newly issued bond.

While there is much uncertainty in the financial markets, including the FOMC and the bond and equity markets, understanding how past market moves have occurred can offer guidance to how increasing interest rate environments may evolve in this rate-tightening environment.

How Soon and Fast Will the Fed Raise Rates?

Will the Fed Raise RatesThere’s much uncertainty surrounding if, how and when the Federal Reserve will raise its rates, end its bond and mortgage-backed security purchases, and wind down its balance sheet. For the March 16 Fed Meeting, the CME FedWatch Tool has a 47.9 percent probability of a 25 to 50 basis point increase, and a 52.1 percent probability of a 50 to 75 basis point increase for their Target Rate. There are many expectations for the Fed to raise its Federal Funds rate, or the so-called overnight lending interbank rate. However, there’s a lot of uncertainty as to how many times the FOMC will increase it.

John Williams, Federal Reserve Bank of New York president, mentioned at a recent event that the Federal Open Market Committee (FOMC) will start raising rates at its March 2022 meeting,  but he isn’t advocating for a particularly hawkish approach. Rather, Williams expects inflation to drop due to supply-chain bottlenecks being naturally worked out, along with the Fed’s measured policy actions moderating inflation. However, James Bullard, Federal Reserve Bank of St. Louis president, is more hawkish and has expressed a desire for a 50 basis point rate hike.

Lael Brainard, a member of the Federal Reserve’s Board of Governors, believes six rate hikes are an appropriate course for monetary policy, starting in March 2022. Charles Evans, Chicago Fed president, blames inflation on the pandemic and echoes that supply chain issues will resolve on their own as the world returns to its new normal. Evans also believes that hiring won’t be slowed with higher rates, compared to past rate hike cycles. However, this could change if inflation grows too high as 2022 progress, necessitating more rate hikes.

The Fed has communicated clearly that it will let 1) evolving economic data, in conjunction with 2) maximum employment, and 3) 2 percent longer-term inflation expectations, guide its monetary policy. Noting there’s been a strengthening labor market, it’ll continuously look at how the pandemic is managed healthwise, how global developments unfold and how inflation is expected to and materializes.

It’s important to note that during August 2020, the Fed took a new approach to inflation. Previously, the approach would be to increase borrowing rates during good economic times to prevent inflation from becoming a problem. However, as of August 2020, the Fed’s new approach is to maintain low rates until inflation actually materialized, permitting economic conditions that drive inflation above and below 2 percent. This would thereby create a longer-term average inflation rate of 2 percent when considering monetary policy adjustments.

This is within the perspective of inflation reaching 7.5 percent year-over-year in January 2022, according to the Labor Department. Month-over-month inflation readings include electricity rising 4.2 percent from December 2021 to January 2022. Food costs rose by 0.9 percent in January 2022, up from another 0.5 percent increase in December 2021.

According to the FOMC’s Jan. 26 meeting minutes, there’s much to be contemplated for any potential rate changes. The members found that inflation was elevated, with economic indicators showing inflationary pressures increased in the back half of 2021. In December, the 12-month change in the consumer price index (CPI) was 7 percent, while core CPI inflation was 5.5 percent over the same period.

The year-over-year November 2021 total personal consumption expenditures (PCE) price inflation was 5.7 percent, with the core PCE coming in at 4.7 percent for the same timeframe. When it comes to the unemployment rate, it fell from 4.2 percent in November 2021 to 3.9 percent in December.

Impact of Russia-Ukraine Conflict

Looking at the price of crude oil alone shows how inflation is fluctuating. On Feb. 24, futures contracts at one point had oil hitting $100 and $105 per barrel for West Texas Intermediate and Brent, respectively. While prices retreated, prices are still elevated and subject to international tensions, increasing demand due to the economy reopening from COVID and uncertainty over future output. Undoubtedly, the Fed will take inflation into account – both its new definition of longer-term 2 percent inflation and how it might impact the economy. Some speculate with the high volatility beginning in 2022, the Fed may raise rates by only 25 basis points, not the 50 basis points more hawkish FOMC members have mentioned.

With increased volatility since 2022 began and global uncertainty increasing by the day, it seems the FOMC will have the final say on how many rate hikes will eventually happen. 

How are Commodity Prices Expected to Impact Earnings in 2022?

Commodity Prices 2022According to the World Bank, there’s a mixed picture for commodities in 2022.

Globally, prices for crude oil are expected to hit $74 per barrel during 2022, compared to 2021’s $70 price tag. This is attributed to greater economic activity as the world continues its reopening. Metal commodities, on the other hand, are projected to drop in 2022 by 5 percent. Similarly, the “softs,” or farming-based commodities, are expected to find an equilibrium or fall nominally in 2022. With much uncertainty related to the pricing of commodities and their impact on 2022’s markets, how have commodity prices impacted company profits and past market cycles?

Earnings, Profits and Measuring Margins

When it comes to evaluating margins, we examine how profitable sales have been after factoring in external and internal costs. Be it at the net margin level, the gross margin level, or the operating margin level, businesses get a wide analysis of their profitability.

There are many reasons companies could see margin pressure, and therefore reduced profitability. Competition, internal production challenges (e.g., rising overhead caused by increases in wages, raw materials, electricity, etc.), so-called “black swan” events such as pandemics, and other geopolitical events impacting commodities and tariffs are among the many reasons for margin pressure.

The World Bank, focusing on the outlook for oil, sees a potential for domestic shale production to pick up less quickly, and the favoring of crude oil versus natural gas. Higher energy prices could slow growth, and the uncertainty of the pandemic could affect energy demand. However, based on reduced investments in crude oil, recovery has fallen since 2014, and again in 2020. Many initially think of the price they pay at the pump. However, indirect costs of increasing crude oil impacts shippers, retailers, airlines, fertilizer manufacturers and farmers, the transportation industry – and the stock prices of those publicly traded companies.

As for other commodities, there are considerations for direct and indirect industry performance. For example, the price of lumber can immediately impact how much homebuilders charge for a new home; however, it also impacts the real estate market, additions, and other industries that use large quantities of wood.

Analyzing Stock Market Sector Performance

When it comes to looking at commodity prices, consumer behavior, and market cycles for the past six decades (starting in 1962), consumer staples have been a steady winner. Looking 10 years back from mid-April 2021, based on Indices, consumer sector stocks grew by 8.2 percent, versus the S&P 500’s annualized returns of 11.86 percent over the same timeframe.

The consumer staples sector is one industry where high commodity prices are likely to impact earnings less than consumer discretionary. With consumer staples a necessity that is independent of the health of the economy, the level of demand is stronger than other sectors. While consumer staples aren’t immune from competition, they are often easier for companies to push price increases through.

In 2022, many Central Banks globally are expected to push a more hawkish monetary policy. Only time will tell whether or not global monetary actions will get a handle on commodity prices and influence markets accordingly.