The Takeaways Two Years After ‘Transitory’ Timed Out

The Fed’s preferred inflation gauge—the personal consumption expenditures (PCE) price index—hit headlines Thursday, cooling to 3.0% y/y in October.^[i] For those keeping score, this reading is below the series’ long-term average of 3.3%, is the slowest rise since March 2021 and isn’t far off the Fed’s 2.0% target.^[ii] These data come two years to the day since Fed head Jerome Powell surprised many by U-turning on the Fed’s position elevated price pressures were “transitory.” Given this, now seems as good a time as any to look back on the inflation spike, last year’s bear market and a few key takeaways.

Conventional wisdom says big inflation and Fed rate hikes caused 2022’s bear market, and we agree to the extent that fear of these items—not to mention worries about the fallout from Russia’s invasion of Ukraine and several other, overlapping issues—hit sentiment hard. But when you consider that markets tend to move ahead of widely expected events, the narrative gets more complicated. Inflation started accelerating in spring 2021, nearly a year before stocks peaked. Starting in April 2021, the Fed and other global central banks called it “transitory,” alleging it would fade on its own in time.

But two years ago Thursday, that changed. A mere week after President Joe Biden renominated Powell for a second four-year term, he told the Senate Banking Committee it was “probably a good time to retire that word and try to explain more clearly what we mean.”^[iii] Hence, the Fed chucked “transitory” in the bin when describing inflation, setting expectations that rate hikes would soon begin. But stocks didn’t peak until the beginning of January.

What changed as January rolled into February, March and beyond? In a word, fear. Inflation coverage got more and more breathless each month, hitting investors hard. It really ratcheted up in February, when Russia invaded Ukraine, and energy prices spiked as investors feared Western sanctions—and Russian retaliation—would bring severe shortages and crank inflation far higher than initially anticipated. When the Fed started hiking in March, talk of the economic fallout ramped up—and kept ramping as rate hikes increased in magnitude through the spring and summer. Recession soon became the baseline economic projection. To the extent inflation and monetary factors played a role in stocks’ downturn, the surprise was the major shift from pre-telegraphed policy (transitory inflation, no major hikes needed) to the historically rapid pace of hikes we got.

By the time October 12, 2022 arrived, nothing everyone feared had really improved. Energy prices, while off springtime peaks, were still elevated—with widespread talk of severe shortages and rationing in Europe. September’s PCE and CPI inflation rates, the latest then available, were at 6.6% y/y and over 8.0%.^[iv] People still feared the return of 1970s-like stagflation. The Fed had just hiked the fed-funds target rate by a historically large 75 basis points (0.75 percentage point) and would do so again a month later. Recession hadn’t arrived, but economists warned the pain was merely delayed—and sure to arrive. That remained the most popular projection as 2023 dawned, and the Fed kept hiking until August (with a brief pause in July). But stocks looked past all of it, rallying in 2022’s final quarter and well into summer 2023. A correction (sharp, sentiment-fueled drop of -10% to -20%) struck late in the summer, but now stocks are off and running again and a whisker away from their year-to-date high (with 2022’s peak a bit beyond).

This new bull market preceded inflation’s return to below-average rates. It also started less than halfway through the Fed’s tightening campaign and well before economists begrudgingly revised away their recession projections. It seems to us markets realized fear had overshot and rallied in relief, pre-pricing all the lagging confirmation that followed.

So no, we don’t think rate hikes and inflation directly caused the downturn. But we do think the sudden shift in the Fed’s entire approach, along with a myriad of other fears, helped sink stocks. So we are quite sympathetic to some aspects of a report that stole headlines Thursday: The so-called Group of 30 or G30’s verdict on central banks’ crisis response and its unintended consequences. The G30, which consists of several current and formal central bank heads and academics, argues the Fed and other major central banks relied too much on quantitative easing (QE) and other “unconventional” policies during early 2020’s COVID lockdown panic, stuck with these too long as inflation accelerated and talked themselves into a tricky corner with too much forward guidance—essentially forcing them to keep policy too loose for too long in order to avoid ruining their credibility with a U-turn.

Now, we would add another unintended side effect of the QE obsession in early 2020: It contributed to the massive money supply spikes that caused inflation in the first place. And it didn’t have much of a discernible economic boost at the time it was most needed, considering lockdowns prevented people from putting that money to use. It wasn’t until later, when economies were reopened and all this excess was still sloshing around the system, that prices really got juiced. This also probably would have taken care of itself as supply chains improved in 2022, adding more goods and services to sop up the surplus funds. The Fed probably could have mopped up the rest by reinstating low reserve requirements (which they dropped to zero in early 2020). Instead, seemingly caving to public pressure, they dropped “transitory” and jacked up rates. The grand irony here is that inflation now looks pretty transitory after all, with supply chain improvement and falling energy prices contributing mildly to this year’s price slowdowns. Prices are still elevated, but fast inflation rates are nowhere near permanent as feared.

We see a few lessons here. First, don’t take Fed words as gospel. They can and do change their mind, as the great “transitory” deletion and rate hike about-face shows. Two, given all these rate hikes haven’t caused recession and stocks have risen alongside them, we think you can tune down the scrutiny and dissection of every Fed meeting and utterance. Three, just because the Fed says policy X will have effect Y doesn’t mean it actually will. QE didn’t bring some massive economic boom any more than rate hikes killed the economy. In reality, both were modest variables affecting the broad economic backdrop, especially with bank lending rather detached from Fed policy thanks to deposit rates’ lingering well below the fed-funds rate.

And four, perhaps most important: Markets move first. They move first on the way down, pre-pricing the potential for bad things to happen. And they move first on the way up, seeing the high likelihood that things aren’t so bad as feared and pricing in the likely improvement. The circumstances change but the behavior doesn’t.