This week in Bidenomics: Bubbles start to deflate
The first week of 2022 brought a middling jobs report, with solid annual wage growth of 4.7% but a disappointing number of new jobs. Employment rose by just 199,000 in December, far less than economists expected. The economy created a record-breaking 6.4 million jobs in 2021, but that was after 9.4 million jobs disappeared in 2020. Total employment is still about 3.4 million jobs below the pre-pandemic peak.
With that out of the way, there’s bigger news that could be the most potent economic force in 2022: The Federal Reserve plans to tighten monetary policy, and this time, it really means it. Minutes from the Fed’s mid-December meeting, released Jan. 5, reveal that the bank plans to raise interest rates more aggressively than previously expected, and perhaps make other moves to settle a bubbly financial sector.
The trigger for the change is inflation, now running at a 6.8% annual rate. For much of 2021, Fed Chair Jerome Powell insisted that inflation would be “transitory.” But with inflation going up rather than down as the year progressed, Powell said in late November that it was “time to retire that word.” At the Fed meeting a couple weeks later, we now know, the Fed changed more than its verbiage. The more hawkish turn will likely now mean three hikes in short term interest rates in 2022, beginning as early as March. The prior outlook was for two hikes, perhaps starting around May. The Fed may also start selling assets from its huge portfolio of securities, which could push up long-term rates as well as short-term ones.
Central bank monetary stimulus has had a huge effect on financial markets and the economy since the Fed jumped into action as the COVID pandemic exploded in March 2020. Stocks have soared 110% since bottoming out on March 23, 2020. The Fed forced mortgage rates to a record low of 2.65% in 2021, which in turn fueled a real-estate boom. Home values have been rising by double-digits and were up 20% year-over-year in the third quarter, according to Census data. That’s great for homeowners, but it has also priced some buyers out of the market and caused other distortions, such as a surge in the cost of building materials for new homes.
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A reversal of Fed policy won’t necessarily send stock and home values plunging. But it will change market dynamics and possibly produce some unexpected twists. And it will probably affect the U.S. economy more than anything Congress or President Biden do in 2022.
Markets have already wavered on news of the Fed pivot. In the two-and-a-half days following the publication of the Fed minutes on Jan. 5, the S&P 500 index fell nearly 2% and the NASDAQ tech-heavy index fell 2.7%. The average mortgage rate has popped up to around 3.22%.
Stock and real-estate markets can afford to lose some altitude. Many analysts think the huge run-up since 2020 has left stocks overvalued. Data from Standard & Poor’s shows the price-to-earnings ratio of the S&P 500 at year-end 2021 was 17% higher than the 10-year average and 43% higher than the average since 1936. During the decade before the pandemic, the average annual gain in home values was 4.2%, barely one-fifth what it jumped to in 2021. Getting back to more normal levels of asset-price growth would probably be stabilizing.
But the pathway might be bumpy. The Fed started a tightening cycle in 2015, with predictable increases in short-term rates. Markets digested those hikes well until late 2018, when stocks fell by 20%. Fed policy wasn’t the only factor involved in the selloff, but the Fed stopped hiking and actually started cutting rates again in 2019—when stocks recovered.
What’s different this time is inflation, which is at the highest level since the early 1980s. If inflation persists, the Fed may not be able to stop hiking, no matter what happens in financial markets. It might not all be bad: The economy still looks solid, on track for growth of 4% or so in 2022. There’s no sign of a recession. Higher rates might also be a relief to fixed-income investors, who have been dealing with near-zero returns for going on two years.
But investors may also be unprepared, after 12 years of extraordinary support from the Fed in the form of quantitative easing and other complex programs. “Even though investors appear to have raised their expectations for Fed rate hikes,” Capital Economics advised on Jan. 7, “we think they may still be underestimating how far the federal funds rate will rise in the next few years.” If that portends a negative surprise, it won’t be good for stocks.
This is not the first concern of President Biden and his economic team. The job market is hot and growth is solid, but inflation is spooking consumers and COVID is maddeningly persistent. Biden promised a return to normal, but it hasn’t happened yet, which explains Biden’s falling approval rating. Voters need something to feel good about, and it may not come until warmer weather helps subdue Omicron or whatever the latest variant of COVID will be by summer.
Six months from now, things might feel a lot better. But the easy gains in risk assets that came courtesy of the Fed for the last 20 months probably won’t be the thing putting smiles on people’s faces any more. Let’s hope something else is.
Rick Newman is a columnist and author of four books, including "Rebounders: How Winners Pivot from Setback to Success.” Follow him on Twitter: @rickjnewman. You can also send confidential tips.
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