Has Fed made a 'public mess' of interest-rate policy?

'Maybe the central bank didn't misread the data but missed the compounding factors'

Has Fed made a 'public mess' of interest-rate policy?

In an effort to douse inflation that’s burning at its hottest in four decades, the U.S. Federal Reserve yesterday took the extreme step of raising its policy rate by 0.75%.

“The Committee decided to raise the target range for the federal funds rate to 1‑1/2 to 1-3/4 percent and anticipates that ongoing increases in the target range will be appropriate,” the central bank said in a statement announcing the steepest U.S. interest rate hike in nearly 30 years.

The statement pointed to continuing supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures as factors driving elevated levels of inflation. Compounding those are Russia’s invasion of Ukraine and COVID-related lockdowns in China.

“If you asked me a couple of weeks ago, I would have said half a percent was the target [rate increase],” says Christopher Warner, a BC-based wealth advisor at Nicola Wealth. “Obviously, the Fed’s biggest concern right now is inflation and tamping it down, and the only tool they really have is rates.”

The current bout of inflation is clearly different and more prolonged than what the Federal Reserve had initially indicated late last year, when multi-decade records first started showing up in the U.S. CPI data. While Warner appreciates the complexity involved in reading economic conditions, he also recognizes that it fell short of the expectations many average citizens, economists, and investment professionals have with respect to monetary policy decision-making.

“Maybe the central bank didn't misread the data they had, but they missed the compounding factors,” Warner says. “Anytime you make a public mess like this, it’s going to detract from your credibility.”

There have been numerous studies over the past few years to indicate that trust in public institutions is extremely depressed. As it stands, Warner argues, central banks are already facing low credibility, and public errors are only going to cause more issues.

“If inflation doesn’t get reined in quickly, it’s going to hurt their voice,” he says. “They also have to balance that against the fact that if they were to move too fast, unemployment could jump too high or there could be a recession, which would still impact their credibility.”

While the uncertainty sweeping through the markets is creating extreme swings of volatility, Warner says Nicola Wealth has been able to sail through smoothly as it follows an evergreen, pension-style approach to portfolio management. That includes access to a variety of institutional offerings that have lifted clients’ portfolios into positive-return territory for the year.

“We’ve been keeping our bonds in short duration, which has helped to protect us,” Warner says. “We also have a pretty healthy position in mortgages, especially floating-rate mortgages. We have a bit of an overweight in preferred shares, especially rate-reset shares, which we see as pretty undervalued to a healthy degree.”

And while many advisors should have had discussions with their clients by now about strategic asset allocation and recessions’ impact on portfolios, Warner believes the recent bear market should put advisors on alert to bring their clients up to speed.

“A lot of clients tend to be in or near retirement, so they’re vulnerable to sequence of return risks,” he adds. “So in those situations, advisors have to make sure they have a strategy in place to minimize the impact of having to draw on depressed assets. … You don’t want to be pulling out 4% of your portfolio in a -20% year, because it’ll be practically impossible to recover and you’ll be ruining retirement from there.”