2021/2022 - Inflation spike & Rate Hiking cycle

[DRAFT - In Progress]

On January 4th, 2022 S&P 500 index touched 4,818.62 as an intraday high, following a relentless rise in its value since the dark days of covid pandemic back in March, 2020 (when it reached a bottom of 2191.86 points). In the previous 1 year and 9 months the index gains 2,626.76 points, or about 120%. So, at least some of the market participants perhaps never imagined what was to come next - in the year that is to follow January 4th, 2022 the index makes a relentless retreat with some amount of range-bound volatility - the index drops to 3,491.58 on October 13, 2022 and then attempts a recovery, 4,13.07 as of this writing.

The Question?

While certain areas of the market has seen tremendous drop in prices, there is no recession that has been declared yet, and still the consumer and employment picture continues to remain strong. So, one might ask - why? Why was 2022 such a bad year not only for stocks, but also for bonds?

The simple answer to that question lies in two factors - a spiking inflation & a fast-paced rate hiking cycle. At least that’s what you’d hear when you go asking for answers. While those are are definitely the most important factors paying their hand on the market, as always our market system is not that simple and there is always more beneath the surface - that is for those who want to explore.

So, in this post we’ll take on the journey to explore the story of the latest inflationary spike and the resulting rate hiking cycle - what were the contributing factors, what has already happened, what is going on and where might we be heading?

We’ll look at this topic from the perspective of US markets first, followed by a review of the related global picture.

The Context

If we are to properly examine this moment in history, we have to the set the context straight first. That context is about the most important factors that are to impact the macro and the micro aspects of our markets. Below are the most-important components of that context from my perspective (at least those that are relevant to the topic in question):

  • Technological innovation over decades and centuries has made technology a key component of our modern economic engine

  • Historically speaking, the highest level of global cooperation that appears to be starting to break down

  • Many years of easy-money policy following the Great Financial Crisis

  • A world that is recovering from the Covid-19 pandemic that has brought in a few changes to the global picture

    • Government-mandated job-losses during the pandemic made the governments (and central banks) attempt to completely wipe out the impact of pandemic by returning to pre-pandemic unemployment levels as fast as they could

    • Additional stimulus, adding to more easy-money

    • A questioning of the global order of high-level of global cooperation and absence of redundancies (integrated supply chains) - degradation of global trust

    • A global attempt at re-creation of a multi-polar world - heightened geo-political risk

Inflation Data

The first data series we’ll look at is inflation data from the US. More-specifically we’ll look at CPI (Consumer Price Index) - as it is directly comparable to CPI of other countries and allows us to maintain a standard view-point. For this article, when we refer to inflation, it means year over year rate of change of CPI.

For the last many decades US has maintained inflation rate at roughly around the 2% range. Many countries (including the US) in recent history have kept 2% as the target rate (though US after 2020 has made some adjustments to that policy) - 2% in general can be considered to be a good rate of inflation considered by most developed economies. In terms of policy decision-making framework, this is what it means:

  • If inflation is meaningfully higher than 2% - economy is overheating and may need to be cooled (slowed-down) if it continues to grow

  • If inflation is meaningfully lower than 2% - economy is slowing down and may need to be warmed up (stimulated) if it continues to decline

Central banks (including the Fed) typically uses interest rates to slow down or stimulate the economy. And the framework mentioned above means that central banks typically do not allow inflation to diverge much from that 2% rate. There are obviously periods when the struggle to correct divergences and times when they allow more more than usual divergence for certain periods of time.

With the recovery from Covid pandemic and the stimulus money still in the system, the economy started to heat up in 2021. Initial recovery was obviously required, but as it appears now the recovery had sufficient momentum to carry it through to a super-heated state. Inflation reads soon started to pick up at unusually high rates (at least for the previous decade). Below is a view of the inflationary picture as capture by US CPI YoY rate of change.

US Inflation rate for the last 20 years (2023 looking backwards)

The chart clearly points to a spike in inflation starting around mid-2021 and peaking in mid-2022. Since then, the inflation headline rate has been coming down. It does not mean prices are not increasing, but rather that rate of price increases have reduced.

Below is a view of the reported CPI data on a monthly basis.

[CPI Data Table]

As CPI data started to come in hotter and clearly above the 2% mark, the Federal Reserve should have been worried. But, that didn’t happen. There were many factors, but below are the ones that appear to have played key roles:

  • Fixing unemployment: Unemployment rate had still not reached the pre-pandemic level and as part of Fed’s dual mandate, they were focussed on employment. This definitely resulted in Fed putting higher weight on employment and less on inflation.

  • Transitory inflation theory: The Fed had a working theory that base effects in inflation rate meant that inflation was supposed to have a spike in 2021, but then would start to subside as the base-effects started to wear off. But, that didn’t happen.

As inflation failed to reverse, in November 2021 the Federal Reserve finally acknowledged the elephant in the room - inflation was indeed not transitory. The good news was that by this time unemployment rate had also pretty much returned to the pre-pandemic level.

And then if not enough damage was already done, geo-politics was waiting in the shadows to come in for the hunt - tension between Russia and Ukraine started to rise and finally Russia invaded Ukraine in February 2022.

Impact of Geo-political events

The Russo-Ukrainian war resulted in immediate panic in certain commodity markets - including natural gas, crude oil, wheat to name a few. Commodities being ingredient in so many products and important sources of energy resulted in price spikes in many markets. This was a second blow to inflation management for the Fed. By March 2022, it was clear that Fed had to hike rates and perhaps by a lot. Even before this point the Fed had already signalled the markets about its intention to not only hike rates and but also start reducing its balance sheet (quantitative tightening).

Rate hike data

The Federal Reserve started hiking interest rate starting from 16 March, 2022 and has hiked rate at every single FOMC meeting. It has increased the federal funds rate from nearly zero in March 2022 to a range of 4.75% to 5% now.

In the table below you can see the hike, the max target rate and the corresponding meeting date.

[Interest Rate Table]

Global picture of inflation & interest rates

The picture around the globe, especially the developed economies, is pretty much the same (with some minor exceptions).

[Global inflation chart]

Considering the rise in inflation across the globe, central banks around the globe have also started on the journey in raising interest rates. As of this writing they are in various stages in this journey.

[Global interest rate chart]

Market data - how the markets reacted

Pictures can indeed say much more than words. The destruction that was 2022 can be seen from the below charts.

[Chart of major indices]

Markets seem to have found their footing starting around October 2022 and has been attempting a recovery. But, it is still to be seen as so where we go from here.

[Table of performance data]

Timeline

Timeline of Inflation, Rate hike, Geo-Politics, and Market reaction data - Let’s put it together in a timeline.

2021 - October

2021 - November

2021 - December

2022 - January

2022 - February

2022 - March

2022 - April

2022 - May

2022 - June

2022 - July

2022 - August

2022 - September

2022 - November

2022 - December

2023 - February

  • February 1, 2023: Federal Reserve raises interest rate by 25 bps to a range of 4.50% to 4.75%

2022 - March

  • March 22, 2023: Federal Reserve raises interest rate by 25 bps to a range of 4.75% to 5.00%

Impact

So, what have we seen in terms of impact that the inflationary spike has resulted in.

Looking Forward

Different scenarios that might play out:

  • Hard-landing/Recession - Fed rate hikes break something OR everything and we go down crashing into a recession

  • Soft-landing - Fed rate hikes slow down the economy but nothing breaks and it avoids a recession continuing to grow at higher interest rates

  • No-landing - Fed rate hikes DO NOT slow down the economy significantly and continues to operate fine at higher interest rates

  • Status-quo-extended - Markets continue to be range-bound, and we don’t see a significant return of inflation

Conclusion

If you look at history, you would find inflation to be a scary phenomenon. Go back to Ancient Roman times, Weimar Republic of the 1920’s, Brazil of 1980’s and Zimbabwe of 2000’s, and you will find examples of severe inflation (or even hyperinflation) accompanied by periods of civil unrest, failing currencies and governments. Severe deflation is not good either - the Great Depression is an example. That is why we need to be concerned about it, worried about it, if it appears to go out of control.

This article is about one specific instance of an inflationary cycle. But this is neither the first nor will it be the last one to come. So, if we take the opportunity to understand it, we will be better prepared to avoid the next one, or in the worst case when we find ourselves in the middle of it, we’ll be better prepared to manage through it.

References

Economy, Finance, BusinessSid Barthakurinflation, Recession, Interest Rate