For the past couple of weeks, we’ve been talking about two things: the war in Ukraine (and its effects) and inflation and the Fed. These have very much been the hot topics, and deservedly so. But with a lull in the news on both, it’s time to check back in on Covid, which has not gone away.

Last week, we looked at what inflation actually is—and where it is coming from. As we noted then, three categories (housing, transportation, and food and beverages) account for three-quarters of all spending. So, if we talk about inflation, this is really what we are talking about. As we also noted, those categories have grown faster since the start of 2021, especially transportation. But none of that tells us what will happen over the next year or so. To determine that, we need to take a closer look.

We’ve talked a lot about higher interest rates and what they mean for the market. But we haven’t really looked at what is driving those higher interest rates, which is inflation. Of course, you see the stats and the headlines, but as usual, there is very little context or explanation as to what those numbers mean. Today, I want to take a look at what inflation actually is.

One of the outcomes from the recent Fed meeting, where the Fed decided to raise rates for the first time in years, was a clear plan to continue to raise rates over the next year. Fed Chair Jerome Powell added fuel to the fire yesterday when he said that the Fed was willing to raise rates even faster than the meeting notes suggested. The Fed is now clearly focused on bringing inflation back down, even if it means slowing down the economy.

This week, we have been talking about interest rates and the Fed—and what that all likely means for our investments going forward. But behind those conversations is another more fundamental question: what should interest rates be? If there is some natural rate where interest rates should be, that could give us some guidance as to where they will end up. That is really what we should be looking for as we plan our portfolios over the long term.

One of the things we know, mathematically, is that if interest rates go up, stocks should go down. If you consider a stock price as the discounted present value of a future earnings stream, then a higher discount rate results in a lower present value. There is no nuance or context; it is just math. So when rates are raised—and prospects for future raises are reinforced—and yet stocks move up, there is clearly something else going on.

With the regular meeting of the Fed this week, there was a great deal of speculation about what it would do. As expected, the Fed pulled the trigger on a 25 bp interest rate hike. But what will happen next? What I expect from the statement, as well as the press conference, is that there will be similar hikes at every meeting for the rest of the year (data permitting) and that quantitative easing bond purchases will be wound down by the end of the year. In other words, I expect the Fed to follow up the rate hike with signals that it will continue normalizing policy, and I don’t expect that to be derailed by the Ukraine war.

Today’s post is going to be a short one because there is simply too much uncertainty right now to make a principled argument about pretty much anything. Interest rates have bounced back up to levels above 2 percent. Will they stay there? Depends on what happens in Ukraine. Stocks are staying somewhat below, but not far below, where they were when the invasion started. Will they go up or down? Pretty much depends on what happens in Ukraine. Oil prices, consumer confidence, inflation, and so forth are all pretty much the same story. We are all waiting on events.

My colleague Sam Millette, manager, fixed income on Commonwealth’s Investment Management and Research team, has helped me put together this month’s Market Risk Update. Thanks for the assist, Sam!

My colleague Sam Millette, manager, fixed income on Commonwealth’s Investment Management and Research team, has helped me put together this month’s Economic Risk Factor Update. Thanks for the assist, Sam!