The Fed, GDP, BBB, and Other Three Letter Words

January 2022 | Victoria Bogner, CFP®, CFA, AIF®

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It’s been nearly two years since the pandemic first reared its head, and the economy is still trying to find equilibrium. From the collapse of GDP in the first half of 2020 to the explosion in earnings growth in the second half, we anticipate the numbers will show we experienced the fastest GDP growth, and the highest inflation since the 1980s.

What we are experiencing is far from normal. There’s no historical analogy. Never have we locked down the country, spent trillions of dollars during peacetime, and had such loose monetary policy. The result was as varied as COVID-19 symptoms are. The broad market has gone higher, although with increased volatility. Bonds have moved lower, with many of them in negative territory in 2021. Small businesses have suffered the most with the staff shortages, high cost of goods, and supply chain disruptions. Big business, on the other hand, had easy access to cheap money and the ability to bend supply chains to their will. So while profits and many large cap stocks have moved higher, Main Street is still trying to recover.

The government’s response to this in the prior 18 months has been more stimulus in the form of checks, higher unemployment benefits, and forgivable loans to small businesses. Regardless of your view of such things, increasing the money supply can cut both ways. It gives consumers more money to spend, but it also can create high inflation in the short term. And that was exacerbated by the disruptions to the supply chain and the huge increase in energy costs. For that reason, inflation has become one of the key pain points heading into 2022 that will have a ripple effect through policy changes, future stimulus packages, unemployment, taxes, and a vast array of other variables.

If inflation is a potential problem, what are the tools to fight it? There are a few. The Federal Reserve can slow down and eventually stop the flow of money going into the economy. They can do that by slowing down what are called “asset purchases.” In the open market, the Fed can buy Treasuries, mortgage-backed securities, and other types of bonds. This floods the market with extra liquidity. By slowing or stopping these purchases, it slows or stops the flow of extra liquidity from those types of open market activities.

The Federal Reserve can also start to raise the Federal discount rate. When you hear commentators talking about the Fed “raising rates,” this is the rate they’re talking about. The Federal discount rate is the interest rate set by the Federal Reserve on funds they lend to commercial banks and other banking institutions. In a healthy economy, all other rates take their cue from this rate. So while the Federal Reserve doesn’t directly affect interest rates you might receive on your savings account or your mortgage, all of those rates are heavily influenced by the Federal discount rate.

At the latest Federal Open Market Committee meeting, the Fed decided to speed up bond tapering. That means that they’re cutting off that extra liquidity faster than originally planned. Once the asset purchases stop, that clears a path for raising rates. As of recently, 2022 growth forecasts have been cut further due to roadblocks in passing the Build Back Better plan, which is an overarching additional stimulus package of $1.75 trillion. These forecasts argue that fewer government handouts will reduce spending and therefore GDP growth.

However, I don’t necessarily agree. And neither do many economists that are taking a deeper view. Less stimulus means a reduction in deficit spending. And with 11 million job openings, normalized unemployment benefits will likely lead to more actual employment. So, any slower growth from less government spending will be offset by more growth from the private sector, which will help supply chains. Also without the BBB plan, tax rates will not rise, which is a good thing for longer-term growth.

Putting it all together, real GDP (GDP minus inflation) is set to be about 3.0% in 2022 with the information we have now. That’s slower than 2021 because GDP in 2021 was boosted by huge amounts of stimulus. But we don’t think GDP will go into the tank because small businesses should find it easier to hire workers and supply chain disruptions should start to ease.

As for 2021’s inflation numbers, it looks like the Consumer Price Index will be 6.5 – 7.0%. The consensus among economists is that will slow down to a range of 3-4%. If that’s accurate, the Fed can take its time raising rates, which will be another positive.

Job growth will most likely continue without stimulus incentivizing unemployment. Job openings are high and so is wage growth, and that should draw people back into the labor force. So while we have an inflation issue that isn’t considered “transitory” any longer, there are positives to come in 2022 in our opinion.

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