Will Inflation and Tapering Cause Interest Rates to Rise?

On November 10, we watched annual inflation reach 6.2%—its highest rate since 1990. A week earlier, the Federal Reserve (Fed) announced they would begin tapering their purchases of government bonds and mortgage-backed securities. Some investors fear that interest rates will sharply rise against this backdrop of high, accelerating inflation and lower bond purchases by the Fed. While this possibility is a risk, it’s far from a certain outcome.

Long-term rates (such as the 10-year treasury rate) are affected by a variety of forces, including expected changes in short-term rates, which the Fed directly influences. They have made it very clear that they do not intend to raise the Fed funds rate soon (or quickly), because they believe that high inflation is transitory. In their view, high inflation will likely subside on its own, and hasty rate hikes would risk upending the economic recovery.

The Fed’s stance has merit. Several drivers of inflation are likely to ease on their own. For instance, the dramatic shift in demand from services to goods is likely to gradually rebalance as COVID cases wane and people’s spending habits normalize. Similarly, COVID-driven production interruptions should lessen, and fading fiscal stimulus should temper spending growth. Individuals should also begin returning to the labor force, drawn by higher wages and declining childcare needs, health concerns, and fiscal stimulus.

However, if inflation runs hotter than expected, rates still aren’t guaranteed to spike, as they did in the 1970s. Today, unlike then, inflation is mainly related to money supply growth caused by massive government deficit spending, rather than private sector loan growth. This distinction is important because Fed rate hikes are likely to be less effective at cooling demand that’s driven by fiscal stimulus. Also, we anticipate fiscal stimulus will diminish in the years ahead as the government scales back inflationary spending packages. For these reasons, the Fed may be more reluctant to raise rates than it would if the private sector was driving money supply growth.

The current period is more analogous to the 1940s, when inflation surged to double-digits on two occasions, yet 10-year treasury rates stayed between 2.0% and 2.5%. During the ’40s, like today, money supply growth was driven by government spending, and the Fed was heavily involved in the bond market. Only time will tell how inflation will evolve and how the Fed will respond, but so far, the Fed seems intent on patiently waiting for labor supply and production to catch up to demand.

Though rates might not surge higher, inflation-adjusted bond returns will likely remain negative. This scenario is problematic for portfolios with an intermediate-term investment horizon that seek to balance short-term volatility and preservation of purchasing power. To hedge against persistently high inflation, we allocate to inflation-sensitive bonds (TIPS), commodities, and/or gold. Due to bonds’ unattractive yields, in some cases we also allocate to absolute return strategies, which seek to earn a positive return that’s unrelated to the direction of interest rates. For long-term investment horizons, equities are generally the best inflation hedge as companies can often pass along higher costs to customers.

Ultimately, diversification is how we navigate an uncertain investment landscape. We help clients diversify by utilizing time frames and various asset classes to address personal financial goals for the short term, as well as the long term.

If you have additional questions, please reach out to your Blue Trust advisor or contact us at 800.987.2987 or email blog@bluetrust.com.

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