Transcript of the podcast:
MIKE TOWNSEND: It’s been a strange start to 2022 here in Washington. Three different snow events in less than three weeks have wreaked havoc on school schedules, twice forced Congress to adjust its own schedule, and saw one of Virginia’s senators stuck on the highway in his car for 27 hours. And last weekend saw the coldest day in the nation’s capital in three years.
But there are bigger issues than just the weather, though the weather may be something of a metaphor for the challenges facing President Biden and the Democrats right now. The White House is struggling to find its footing as two of its key domestic priorities―the Build Back Better Act and voting-rights legislation―have collapsed. The president’s approval rating is stuck in the low 40s, causing anxiety as Democrats gear up to defend their narrow majorities in the midterm elections.
Inflation is up to levels we haven’t seen in four decades. Supply chain bottlenecks persist. Unemployment is nearly back to its pre-pandemic lows―yet businesses across nearly every sector are struggling to find enough workers to meet customer demand.
All of this is creating new challenges at the Federal Reserve, which appears poised to increase interest rates to combat inflation just as a trio of new faces have been nominated to the Fed’s Board of Governors to help guide monetary policy in this complicated economic environment.
Many investors are unsure of what to make of it all. And the markets have reflected the uncertainty of investors, with the S&P 500® down nearly 3% since the calendar turned to 2022.
Welcome to WashingtonWise, a podcast for investors from Charles Schwab. I’m your host, Mike Townsend, and on this show, our goal is to cut through the noise and confusion of the nation’s capital and help investors figure out what’s really worth paying attention to.
Today, we’re going to shake up our usual order of things a bit. While my conversations with guests typically come in the middle of the episode, right now investors are anxious for answers. So I want to get right to my Deeper Dive, where we are going to discuss the outlook on inflation, where interest rates are headed, the jobs market, and what the Fed can do to balance it all.
That’s a lot to cover, and I’m pleased to have Kathy Jones, Schwab’s chief fixed income strategist, joining today to share her insights. Kathy, welcome back to the podcast.
KATHY: Thanks, Mike, it’s great to be here.
MIKE: Well, Kathy, let’s begin with what I think is on the mind of most everyone these days, and that’s inflation and how to bring it under control. Many things have contributed to the rapid rise. It probably started with all the pandemic relief money going into people’s pockets. COVID shut down so many services, so that money was spent on goods. That increased demand took its toll on the supply chain and drove up prices. Along the way energy prices jumped up, and that has far reaching impact beyond just heating our houses and fueling our cars. Energy costs factor into the prices of just about everything.
This is where we turn to the Fed. After all, managing inflation is part of their mandate. Last fall they said they would begin tapering the central bank’s massive bond-buying program, which was part of the 2020 steps the Fed took to rescue the economy as the pandemic started. Then they said they would accelerate the tapering. And now, consensus is that they will begin raising interest rates in March.
So, Kathy, what do you make of all this―can the Fed actually affect the kind of inflation we are seeing now?
KATHY: Well, Mike, the answer is yes―but it comes at a cost.
So you’re right to point out that much of the increase in prices we’re seeing is due to this supply/demand imbalance created by the pandemic and the policy response to it.
Here’s the conundrum for the Fed: The folks at the Fed can’t increase oil production or clear up the logjams at ports or make more computer chips to go into cars. They also don’t have control of fiscal policy. The only tool they really have is monetary policy―and that works on the demand side. So what they can do is tighten policy by raising interest rates and taking other steps to slow down growth of demand, which should bring down inflation. It can certainly be done, but the cost is likely to be slower growth and probably higher unemployment.
MIKE: We’ve seen a lot of what I would call breathless hyperbole in the media over the last few weeks. We keep hearing that this is “the end of an era” or “the end of easy money.” In fact, there’s talk that there could be as many as four rate hikes this year.
Do you think that’s likely, and how high do you think they might go?
KATHY: Well, you’re definitely right about the “breathless hyperbole,” but this, I think, happens almost every time a cycle turns. The consensus coming into the year was that the Fed would probably not even start raising rates until 2023, and now there are predictions of four rate hikes or more. I think it reflects how off-base a lot of economists were just a few months ago. I personally think three rate hikes of a quarter point each starting in March is more likely based on what we know now. That would put the fed funds rate―which is the base lending rate in the financial system―at 0.75% by the end of the year.
Now, that may not seem like a lot―but consider that when the Fed raises short-term interest rates, it tends to affect all interest rates. It ripples through the economy. And short-term interest rates have been at zero for a couple of years, so it can be quite a jolt because it drives up borrowing costs.
Whether it’s the end of an era is a big question. There are some fears that inflation―having emerged after this very long sleep―will stay high. For that to be true, it would really need to be a policy choice by the Fed to allow it to happen. And I seriously doubt that’s the case.
However, I do think investors need to be prepared for the change from very easy money policies put in place in 2020 at the start of the pandemic to something “less easy,” or even “tight,” over the course of the next year or so because the Fed is talking about reducing the size of its balance sheet.
Now the big surprise coming out of the minutes of the Fed’s December meeting is that there was a really robust conversation about lowering the size of the balance sheet, which is otherwise known as quantitative tightening. And what that means is that the Fed not only stops buying bonds, but it also stops reinvesting the principal and interest it receives―so effectively when the bonds mature, the Fed’s holdings decline. It’s not the same as outright selling bonds―which is also an option―but far less likely to happen any time soon.
It was a surprise that the Fed even discussed this because the last time the Fed tried to pull back on this kind of very easy policy―they didn’t start shrinking the balance sheet until nearly two years after they started rate hikes.
I think the Fed’s reasoning this time around is the economy is booming, inflation is high―and there’s really no longer any reason for it to be holding so many bonds to try to push down interest rates. And it’s just another tool that the Fed can use to fight inflation, but it does mean less money circulating through the financial system.
MIKE: Well, we’ve seen a kind of rocky start to the markets, so far in 2022, in anticipation of rate increases. So how do you think multiple rate increases will affect the stock market and the fixed income market this year? How fast and how high can the Fed raise rates without spooking Wall Street―after all, that easy money sure helped drive stock prices up.
KATHY: It’s definitely likely to have some negative impact―especially on the riskier segments of the markets―like, you know, tech stocks with no earnings or very low-rated bonds issued by companies that are burning cash. It’ll also likely have a negative effect on areas of the market that are the most speculative and have seen the most leverage.
And that’s really because when the risk-free rate is zero, which is what the Fed controls, with short-term interest rates, a lot of investments look good by comparison. When that risk-free rate moves up, the value of those investments tends to decline. It’s just the way the math works in investing. The weaker the fundamentals and the higher the leverage in those investments, the more impact a rate hike would have.
But the Fed isn’t trying to throw the economy into recession, so the stocks and bonds of companies with good solid business models, and earnings power, and adequate cash flow should be fine. Same story with municipalities. Many benefited from the government aid provided during the pandemic and have been doing very well as the economy recovered. So higher interest rates really shouldn’t derail them because many have locked in low borrowing costs for a very long time.
MIKE: Well, Kathy, as you noted earlier, the Fed can’t fix supply chain issues. It also can’t fix the pandemic or the fact that a lot of people are rethinking exactly when, and how, and where they want to work, all of which are impacting the economy right now. But along with managing inflation, maximum employment, and moderate long-term interest rates are also part of the Fed’s mandate. So what’s their goal right now? Is it combating inflation? What about job creation? Are these two things in competition, or are they compatible? Does the Fed have the right tools in its arsenal for this fight?
KATHY: Well, Mike, in an ideal world, the Fed can manage what we call a “soft landing” where inflation declines, unemployment doesn’t go up too much, and the economy continues to grow at a reasonable pace―but not too fast. Now that’s easier said than done―especially when you are starting from a very high level of inflation, as we are now.
Now the main way the Fed tries to accomplish this is by tightening financial conditions. And that’s generally is done by making money more expensive and harder to borrow.
So raising interest rates will affect all kinds of loans for individuals and businesses—car loans, mortgages, money that a company might borrow to add inventories. And that raising of rates will tend to reduce borrowing and consumption. Now other ways financial conditions tighten might be through a stronger dollar―which makes imports more expensive and by increasing the risk premium lenders demand from borrowers. For example, when a corporation issues a bond to raise money for expansion, it pays some amount of yield over the Treasury yield. That’s called a “spread.” That spread tends to narrow when the economy is booming, and the banks and investors have a lot of money to lend, and then it tends to increase in times when Treasury yields go up and the economy is slower. In other words, the lenders want a higher “cushion” to compensate for the risk of default.
Unfortunately, it probably means accepting higher levels of unemployment at the same time. By slowing down growth to cool inflation, it could mean that there aren’t as many jobs available because businesses slow down. But right now, with a very strong job market and rising wages, that’s a trade off the Fed makes to get inflation down.
MIKE: Well, Kathy, as our resident Fed whisperer, let me get your thoughts on what’s happening over at the Fed itself. We’re looking at significant turnover in the next few months.
First off, it’s widely believed that Chairman Powell, who had his confirmation hearing for a second term as chair of the Fed’s Board of Governors last week, will be confirmed. And Lael Brainard appears likely to be confirmed to move from being a regular Fed governor to the vice chair position.
But the seven-member Fed has three other vacancies, and late last week President Biden announced his choices to fill those seats. He’s nominated Sarah Bloom Raskin, who served on the Fed board from 2010 to 2014, to be the vice chair for supervision, an important position that has primary responsibility for the regulation of the nation’s largest banks. He also has tapped two economists, Lisa Cook and Philip Jefferson, to fill the other two open seats. All three will be going through the confirmation process over the next several weeks.
This is really an historic moment for the Fed. If they are confirmed, Cook and Jefferson would be just the fourth and fifth Black Fed governors, and Cook would be the first Black woman. There also would be four women on the board for the first time ever. And―and I found this unbelievable―it would actually be the first time since 2013 that all seven seats are filled―that there are no vacancies.
Once confirmed, these new faces will be part of the decision-making process at what I think is one of the most unique times in the Fed’s history. And let’s keep in mind, these appointments are for 14 years. So unless they choose to resign, they continue in spite of any changes in administrations that are coming ahead.
How do you think these new governors will impact the Fed’s decisions in the months and years ahead? Do you anticipate any fundamental change in direction in terms of doves and hawks?
KATHY: Well, Mike, the nominees that were just announced generally lean towards being “doves”―that is, they’ve argued for keeping rates low to boost job growth, and they tend to have a more expansive view of the Fed’s mission than, say, some of the other members.
So just to clarify for listeners―the Federal Reserve is composed of a board of governors plus the presidents of the regional Federal Reserve banks. The people on the board always have a vote on policy, through the Federal Open Markets Committee meetings―that’s the body that meets every six weeks and makes decisions on things like interest rate policy. But the regional Fed presidents rotate in and out of that committee to make sure there’s plenty of representation from various parts of the country. The governors are nominated by the President, while the regional Fed presidents are appointed by the boards of their banks.
In recent years, really, the Fed has been “dovish” up until inflation started to move up sharply. Doves tend to favor keeping rates low to see how far they can push the unemployment rate down. And, up until the pandemic hit, the Fed was generally in agreement that it could let the economy run a little “hot” to push unemployment down since inflation had really been low for a very long time. And now, just about everyone at the Fed agrees that it’s time to rein in inflation―so there aren’t really a lot of doves around anymore, now that they’re starting to raise rates.
But I think the big philosophical differences may be on things like what the Fed’s role is―or isn’t―in addressing things like climate change, or income inequality, or investor protections. For example, the Fed might take into consideration how the impact of climate change might affect the economy when setting policy. That’s not something they’ve done in the past. They might try to assess how much of a risk is it to growth that they might want to offset with policy.
Now the Fed also plays a big role in the regulation of banks. It can take actions that affect, for example, lending in areas maybe affected by climate change or in requiring higher levels of investor protections in some markets. And after the financial crisis, the Fed required banks to hold a lot more capital to protect against future crises. The departing vice chair for regulation, Randal Quarles, was in favor of loosening some of those rules on banks. But others, and I think Raskin will be in this camp, would likely favor keeping them in place.
But―when it comes down to monetary policy, setting interest rates―I would note that despite fairly wide differences we’ve seen over the years among various Fed appointees―its decisions have tended to be driven by consensus, and the economic analysis done by the staff is really shared by all. So dissenting votes actually are unusual because by the time the meetings come around, a lot of these differences have already been hashed out.
MIKE: Well Kathy, let’s end with this. Given everything that’s going on―the changes at the Fed, rising inflation, the challenges in the economy―what do you think is the big takeaway for investors as we look ahead to 2022? Is there something investors should be doing or thinking about right now?
KATHY: Well, a couple of things come to mind, Mike. First, you know, look for the Fed to hike rates this year and to begin reducing its balance sheet, and to a large extent now that’s already built into market expectations―but it’s likely to be a volatile process, so we think that this year is going to be a pretty volatile year in the markets.
Secondly, the riskier segments of the markets―whether it’s the stocks of companies that don’t generate any profits or very low-rated bonds―may struggle. Look out for places where there isn’t a lot of liquidity or there is a lot of leverage―those are usually the markets that react the most to tighter financial conditions.
And then thirdly, I would just say, optimistically, for many investors, rising rates present an opportunity. Investors who’ve been hoping for better returns from low-risk investments―like bonds―they should be able to find those higher yields without having to stretch into the junkier parts of the market. So if you’re a buy-and-hold investor, rising rates can mean better starting valuations and returns over the long run. You just have to manage through the volatility in the short run.
MIKE: Well, it’s sure going to be an interesting few months to see how the Fed and its new members navigate this rapidly changing environment. As usual, Kathy, you’ve really helped make sense of it all. Thanks so much for your time today.
KATHY: It was a pleasure, Mike.
MIKE: That’s Kathy Jones, Schwab’s chief fixed income strategist. Be sure to follow her on Twitter @kathyjones.
Elsewhere in Washington, it’s been a tough few weeks for the Biden administration’s legislative agenda.
Right before Congress broke for the holidays, the Build Back Better Act collapsed in the Senate. That’s the roughly $2 trillion bill focusing on climate change and social programs that passed the House of Representatives in November. It represents the heart of the president’s domestic agenda.
But formal debate on that bill never even got going in the Senate, as moderate Democratic Senator Joe Manchin of West Virginia made it clear that he objected to the size, scope, and some of the specifics in the House-passed bill. The White House and Democratic leaders on Capitol Hill spent much of December negotiating with Manchin, but those talks fell apart right before the holidays. With the 50-50 tie in the Senate, and Republicans united in opposition, the Democrats need every single one of their members to vote for the bill in order to be able to have Vice President Kamala Harris cast the tiebreaking vote and pass the legislation.
As 2022 began, Manchin indicated that he would be open to continued discussions about a slimmed-down bill, but there’s been little if any progress made since. The challenge is that reducing the size and scope of the bill to accommodate Manchin risks alienating progressives, in both the House and Senate, who are already angry that the bill is smaller and less ambitious than they wanted. Optimism about reaching a compromise is low right now on Capitol Hill. But I think it’s too early to say that there’s no chance of some kind of agreement.
For investors, the important thing to know is that if the Build Back Better Act is in limbo, that means that the tax provisions we have been discussing for months also remain in limbo. The House-passed version of the bill called for a new surtax on wealthy individuals, an increase in the state and local tax deduction, a new corporate minimum tax of 15%, and a new tax on stock buybacks, among other things. There was also a provision that would have impacted retirement savers, by banning what is known as a “mega backdoor Roth conversion.” That’s a technique where wealthy filers can skirt the income limits on converting traditional retirement accounts into Roth accounts. All of those provisions were to have gone into effect on January 1―but only if the bill passed Congress and was signed into law before that. Of course, that did not happen and so those tax provisions did not take effect.
One of the key open questions about the bill is what happens to those tax proposals if a revised version of the Build Back Better Act comes back to life? Will Congress keep those provisions in the bill? If the bill is smaller in size, would lawmakers need all of those tax provisions to pay for the bill? Which ones would get dropped? Or would different tax provisions be used? And, if a revised bill comes together in the coming weeks, would any of those tax provisions be retroactive to the beginning of 2022?
The answer to all of those questions is that we just don’t know. For now, the news is simple: There is no news. None of the tax code changes that were proposed over the last six months of 2021 have come to pass―at least not yet. So stay tuned, as we’ll be following this closely if and when negotiations on a revised Build Back Better Act pick up steam again in the weeks ahead.
Speaking of looking ahead, what else is likely to be on the Congressional agenda in 2022? Well, it’s a midterm election year, and that often means a light legislative agenda, as neither party wants to give the other any advantage going into next fall’s elections.
But there’s one thing on the agenda that markets will be keeping an eye on as we heard towards February: Once again, we’re coming up on a deadline for a potential government shutdown.
The current temporary agreement to keep the government open and operating expires on February 18. This stems from the fact that Congress still has not passed a single one of the 12 appropriations bills that fund every government agency and every federal program for this fiscal year. And the fiscal year started back on October 1. While missing the October 1 deadline is, itself, not unusual, it is fairly unusual to still have made no progress by February, nearly halfway through the government’s fiscal year.
To ensure there is no government shutdown, Congress passed a temporary measure that just funds all agencies and programs at the same level as last year, back in September. When that first temporary measure ran out in December, they passed a second one that runs through February 18. Now, that new deadline is approaching.
The issue, though, is that these temporary measures just perpetuate previous funding decisions. They don’t allow for any adjustments, or any prioritization, any ability for Democrats, who hold the majorities in both the House and Senate, to increase funding for programs they support and decrease funding for ones they don’t.
The good news is that last week, a bipartisan group of lawmakers began formal meetings to flesh out a budget for the remainder of the year. Both sides have an incentive to do so. Democrats would like to see an increase in spending on domestic programs, while Republicans would like to see more defense spending. A compromise is achievable, and the negotiating group is looking to try to put together one giant bill that includes all 12 appropriations bills. Whether that can be done before the February 18 deadline remains uncertain, but the sense on Capitol Hill is that lawmakers would be willing to pass another short-term extension if they needed another week or two past that date to finalize the details.
At this point, a government shutdown next month looks unlikely, though it will continue to loom as a possibility. The sense, however, is that given everything going on in the economy right now, a government shutdown is one thing it doesn’t need. So look for lawmakers to find a path forward that settles government funding for the remainder of the fiscal year. Of course, once that’s finished, they’ll have to start the process all over again to fund government operations for next year before the October 1 deadline in the fall.
Finally, on my Why It Matters segment, I like to note something interesting that’s happening in Washington that may have been below the radar screen and explain why I think it’s important.
Over the last few months, we’ve heard a lot about government officials getting in trouble for their investments and whether they are using their inside knowledge to make trades to their benefit. This has been particularly true at the Federal Reserve.
Earlier this month, Fed Vice Chair for Supervision Richard Clarida resigned his post two weeks before his term was coming to an end after it came out that he had failed to disclose trades that he made in February 2020, just as the pandemic was taking hold.
Last fall, the presidents of the Federal Reserve Bank of Boston and the Federal Reserve Bank of Dallas both resigned because of trades they had made in early 2020.
Fed Chair Powell has put in place tighter restrictions on when and what Fed officials can trade, including a ban on the purchase of individual stocks or bonds, 45 days advance notice for any trades, a requirement that all investments be held for at least a year, and new, more detailed reporting requirements.
Trading by Members of Congress has long been an issue, too, with multiple lawmakers coming under scrutiny for their trading activity, even though a law exists that governs how members of Congress and senior staffers may trade and how that activity is reported. Senator Richard Burr, a Republican from North Carolina, is under investigation by the SEC for trades he made in 2012, and he announced last year that he would retire from Congress and not run for re-election this fall.
But a recent investigation found that violations of the law are widespread on Capitol Hill. And that has triggered a sudden enthusiasm for passing tougher laws for members of Congress and other federal officials when it comes to investing.
Just in the past few weeks, at least a half dozen bills have been introduced on Capitol Hill, most of which would ban Members of Congress from trading at all during their time in office or require them to put their investments in a blind trust. House Minority Leader Kevin McCarthy, a Republican from California who has a good chance to be the next speaker of the House if Republicans win the majority this November, recently said that he would push for such legislation next year.
But now it feels like it might happen before that. While it is still early in the legislative process, momentum is growing on Capitol Hill for action in this area this year. I’ll be keeping an eye on this because lawmakers understand that the optics of the past few months, with stories about government officials profiting in the early days of the pandemic, are bad.
Well, that’s all for this week’s episode of WashingtonWise. We’ll be back with a new episode in two weeks, so please take a moment now to follow the show in your listening app so you don’t miss the next episode. And if you like what you’ve heard, leave us a rating or a review—that really helps new listeners discover the show.
For important disclosures, see the show notes or schwab.com/washingtonwise, where you can also find a transcript.
I’m Mike Townsend, and this has been WashingtonWise, a podcast for investors. Wherever you are, stay safe, stay healthy and keep investing wisely.
After you listen
No one is happy with the recent inflation run-up, least of all the Federal Reserve, whose mandate includes keeping inflation at a manageable pace. For this fight, one of the main arrows in the Fed's quiver is to raise interest rates in hopes of curtailing spending and bringing prices back in line. But how much will it take, and how painful will that be for the economy? Kathy Jones, Schwab's chief fixed income strategist, joins Mike Townsend to consider how far the rate hikes will go, what the impact may be on jobs and the markets, and how the new faces soon to join the Fed could impact the decision-making process at the central bank.
Mike also looks at how the stalled Build Back Better Act means that a host of tax increases that investors thought might go into effect in 2022 remain in limbo—and whether they might come back to life if a new version of the bill emerges. He examines the risk of a government shutdown as Congress scrambles to fund the federal budget ahead of a February 18 deadline. And he discusses emerging bipartisan support for measures to prohibit government officials from using inside knowledge for their personal investing.
WashingtonWiseis an original podcast for investors from Charles Schwab.
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