The Federal Reserve pivots to a new policy as the expansion matures

by Badgley Phelps | Jan 27, 2022

Outlook: First quarter 2022


The U.S. economy expanded at a fast pace in 2021 and growth of approximately 5.5 percent is expected when the fourth quarter numbers are finalized. Aggressive stimulus programs from both the federal government and the Federal Reserve have fostered a dramatic rebound. As we progress into 2022, the expansion is poised to continue. However, this year growth is expected to moderate to a rate between 3.5 and 4.0 percent given a retreat from last year’s stimulus programs. The Federal Reserve is expected to raise short-term interest rates three or four times this year, and they may also attempt to increase long-term interest rates by selling some of the bonds that are currently held on their balance sheet. In addition, the federal government is not expected to implement aid packages anywhere close to the magnitude of the CARES Act or other stimulus measures that were enacted in 2020 or 2021. In fact, as we enter 2022, it is not certain that the Build Back Better legislation will pass and even if it does, it will result in far less fiscal stimulus relative to the programs enacted over the last two years.


The combination of aggressive government stimulus programs and supply chain issues has resulted in a dramatic increase in inflation and has become a key driver for risk assets. In December, the Consumer Price Index registered a year-over-year increase of 7.1 percent, the highest level in 40 years. The price increases were broadly based, but the biggest gains occurred in oil, food, and other commodities as well as in the price of vehicles. The high rate of economic growth and a significant increase in wages has resulted in strong demand. At the same time, supply chain issues have constrained supply. This has resulted in a perfect storm for consumer prices, and they show no signs of falling in the near term. Later this year inflation may decline if the supply chain issues are resolved, but it is likely to settle at a level higher than we’ve enjoyed over the last ten years given strong demand for goods and services as well as the persistent shortage of labor and resulting wage gains. While the long-term outlook for inflation is uncertain, in the near-term price levels are expected to remain elevated.

U.S. dollar

The U.S. dollar increased significantly last year driven by numerous factors including an expectation of rising interest rates in the U.S. and the relative strength of our economy. New variants of COVID-19 and waves of outbreaks also served to keep the dollar elevated. Looking forward, we expect our currency to remain strong driven by the Federal Reserve’s plan to engage in a series of interest rate hikes, ongoing uncertainty related to COVID-19, and the continuation of the economic expansion.

Asset class

Cash/Money Market Instruments

Short-term interest rates have increased since last November’s announcement by the Federal Reserve of a reduction in monthly bond purchases. As inflation has remained stubbornly high, the central bank has become more aggressive in reducing monetary accommodation and plans to scale back purchases of Treasuries and mortgage-backed securities by $30 billion a month. At its current pace, this stimulus program is scheduled to be terminated in March. Additionally, the updated Summary of Economic Projections from the Federal Reserve’s December meeting indicated the central bank had become more attentive. The updated forecast calls for three increases in the federal funds rate of one quarter-point in 2022. This represents a stark contrast to the September projections which indicated a split decision on whether any rate hikes were appropriate for 2022. While tapering the amount of bond purchases isn’t tightening monetary policy, a gradual reduction in these purchases is the first step toward eventually hiking the Federal Funds Rate. With a more proactive Federal Reserve, the current expectation is that the first interest rate hike could occur as soon as March. The aggressive, crisis-based policies of the Federal Reserve have served as a tailwind for both stocks and bonds, and the evolution in their policy could also be a catalyst for a change in the tone of the market.

Intermediate Government/Credit Bonds

The yield on the 10-year U.S. Treasury was volatile last quarter but ended the period almost unchanged. Given expectations for three to four rate hikes in 2022, short-term interest rates have increased with the yield on the 2-year U.S. Treasury rising from 0.29 percent to 0.75 percent last quarter. The Federal Reserve has significantly shifted their policy to address near-term inflation concerns, while long-term inflation expectations remain close to the long-term average at approximately 2.5 percent. This is notable given the elevated inflation readings in recent months. Additionally, economic growth is expected to begin the normalization process in 2022, slowing from last year’s pace and moving closer to its long-term trend. This suggests an upward trajectory to interest rates in the coming year, but yields are likely to remain low by historical standards. Credit spreads, which are the difference in yield between corporate and U.S. treasury bonds, increased in November and December. The investment-grade credit spread remains tight in a historical context yet is elevated compared to the beginning of 2021. Fundamental credit metrics are healthy and continue to improve for investment-grade bonds, yet this is at least partially mitigated by expectations for a surge in corporate bond issuance in January as well as a circumspective view of a flattening Treasury curve.

Tax-Exempt Municipal Bonds

Municipal bonds performed relatively well in 2021. Broad credit concerns failed to materialize as the economy recovered much quicker than expected. We have a positive view of the credit quality of most issuers in 2022 as stronger tax and service revenues allow for greater financial flexibility. Strong capital markets have also benefitted pension plans though there remain large variations across the group with some states lagging others.

U.S. Equity

After two years of a boom-and-bust environment, we expect a normalization in 2022. This means growth rates that are more consistent with the historical norm and more volatile market activity than we experienced last year. The ongoing economic expansion provides a strong fundamental backdrop for the stock market. That sets the stage for a sustained increase in corporate earnings with profits expected to increase about eight percent this year. The stock market generally follows the trajectory of earnings, so rising profits should be supportive of equity prices. However, uncertainty surrounding COVID-19, persistent inflation, and the withdrawal of stimulus pose risks and we expect these factors to be sources of volatility this year. Inflation reduces demand and ultimately slows economic growth. It also threatens to reduce margins across corporate America as the price of inputs is rising along with the wages that workers are demanding. To date, many companies have been able to pass along rising input costs by raising prices. However, it remains to be seen how long they can offset these margin pressures. In response to rising inflation, the Federal Reserve is rapidly changing course from the aggressive stimulus policies implemented during the pandemic to a more restrictive stance. This shift is more art than science and there is the risk of an overshoot in which policy is tightened too much, resulting in the economy slowing more than desired. Collectively, growth in the economy plus rising earnings coupled with high inflation and a withdrawal of stimulus, provide opposing factors that set the stage for an increase in market volatility in 2022. In this environment, we expect a market that moves in fits and starts rather than the persistent upward trajectory we enjoyed last year.

International Equity

Consistent with domestic equity markets, we expect the global economic expansion to continue and rising corporate earnings to be supportive of foreign markets. However, many countries are in the midst of a transition that is similar to what we are experiencing here in the U.S. Central banks in many developed countries are shifting away from the emergency policies they employed at the outset of the pandemic and adopting more restrictive stances. Consequently, these markets may also experience some bouts of volatility in the coming year. Volatility could also be driven by COVID-19 as outbreaks have more of an economic impact in some countries than others. This is a function of the uneven distribution of vaccines and the fact that some governments are employing lock-down policies during outbreaks. Accordingly, the trajectory of the virus is likely to have a more significant impact on foreign economies, particularly those in the emerging markets where vaccines are less prevalent, and lockdowns are more widely employed. On a positive note, valuations are attractive in the foreign equity markets and improvement in containing the virus could set the stage for an equity market rally.


Commodity prices increased significantly after bottoming in the spring of 2020, and the gains have been broadly based. Looking forward, we expect prices to remain elevated. Consumer net worth is at record levels and the ongoing economic expansion should sustain high levels of demand for finished goods. At the same time, supply constraints and bottlenecks in the supply chain are leading to rising input prices, long delays in production, and shortages of some products. The combination of these factors is making consumers and producers less sensitive to rising prices for source inputs while increasing the focus on fulfilling demand.

Potential opportunities & risks


New opportunities/new markets—The outbreak of COVID-19 has presented a unique set of challenges. It also provides businesses with a unique opportunity to differentiate and develop new markets. By some estimates, technology has been pulled forward two to three years and new products and services are in high demand. Prevalent themes include the increased use of technology, home improvement, home ownership, products and services that facilitate working from home, and a significant increase in the use of online retail relative to shopping in stores.

The emergence of new technologies—The convergence of cloud computing, significant increases in computing power, and the advent of the smartphone have created a connected world in which new technologies change the way we live. This convergence has created investment opportunities centered around long-term themes in which disruptive companies can capture high levels of market share in a relatively short period of time.

The evolution of finance—Technological advancements are disrupting traditional methods of banking, finance, and transfers of cash. For example, we are experiencing a global shift from paper currency to electronic payments fueled by the popularity of credit and debit cards. Online payment systems facilitating money transfers, e-commerce, buy-now-pay-later arrangements, and electronic bill paying services are also experiencing strong demand. This shift is still in its early stages and is expected to have a long runway as it is occurring across both the developed and the developing economies. In the coming years, blockchain technology may become a significant disruptor in the finance industry with opportunities for new entrants while creating risks for the firms that currently dominate this space.


Setbacks in the re-opening of the economy—The rate at which vaccines have been developed is unprecedented. However, variants of the virus and the uneven distribution of vaccines globally could be problematic and may slow the rate at which we can return to more normal lifestyles. In addition, some countries are employing lockdown policies when outbreaks occur meaning cities, ports, and manufacturing facilities are shut down from time to time. Accordingly, future outbreaks threaten to extend the supply chain issues and corresponding inflation we are experiencing today.

Debt related issues—Sovereign debt levels were rising prior to the outbreak of COVID-19. However, in the wake of the virus, debt has increased significantly. In the U.S., government debt has increased approximately 30% since the end of 2019 and that trend shows no sign of reversing course.

Inflation—Given the unprecedented amount of fiscal and monetary stimulus, supply chain bottlenecks, a shortage of labor, as well as the Federal Reserve’s policy of allowing higher rates of inflation, there is a risk that the recent increase in price levels may persist and be harder to contain than policy makers anticipate.

Increasing government regulation of technology companies—Several of the leading technology companies have established dominant market positions and have few competitors. As the power of these companies continues to increase, government regulators are placing them under greater scrutiny by assessing their privacy policies, acquisition plans, and competitive practices.

Geopolitical risks—Conflicts in many parts of the world have escalated or have near-term catalysts that may result in a change in dynamics. We are closely monitoring developments with Russia and Ukraine as well as those between the U.S. and China as tensions remain elevated.

Cybersecurity—Cybersecurity remains a significant issue as evidenced by persistent attacks on governments, businesses, and individuals worldwide.


Originally posted on January 27, 2022


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