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Vanguard has emphasised for months that markets have underestimated just how high interest rates will have to go to quell inflation. Our economic and market outlook for 2022 discussed the delicate balance policymakers have to maintain between keeping inflation expectations anchored and supporting economic growth. 

Consumer prices that have since reached multi-decade highs globally, exacerbated recently by elevated oil prices related to Russia’s invasion of Ukraine, have attuned markets to the reality that inflation won’t come down magically. 

Central banks no doubt have a challenge ahead. We believe the US Federal Reserve, for example, will eventually need to raise its federal funds rate target to 3%, if not higher, from 0.25-0.50% currently. 

Yet we also believe that higher interest rates will cool, but not stop, labour market strength and economic growth. And that the recently begun normalisation of monetary policy will bring with it a normalisation of asset returns, restoring balance to financial markets that lately have relied too heavily on large-cap growth stocks, not least technology companies.

Years of accommodative policy are coming to an end

Years of accommodative policy are coming to an end

Notes: Vanguard’s proprietary monetary policy measurement examines the effect of the policy rate, central bank asset purchases and inflation relative to the neutral rate of interest to gauge how “tight” or “loose” policy is. Values below zero reflect loose, or accommodative, policy; values above zero represent tight, or restrictive, policy.

Sources: Vanguard calculations, based on data from the Federal Reserve, the US Bureau of Economic Analysis, Laubach and Williams (2003), and Wu-Xia (2016).1,2 Accessed via Moody’s Data Buffet as of 11 January, 2022.

For several years, our annual economic outlooks have presented forecast ranges for 10-year annualised asset class returns that have been progressively lower than the year before. Lofty stock market valuations have no doubt been part of that story for our share forecasts, but more so has been the near- or below-zero real interest rates that have encouraged investors to pay more now for future expected cash flows.

For several years, we’ve talked about the role of secular forces such as globalisation and new technology in keeping interest rates and inflation low.

As a result of these forces, central banks including the Bank of England and European Central Bank have found themselves challenged ever since the global financial crisis to push inflation upwards towards their 2% targets. For much of that time, their concern has been deflation, not inflation.

And for several years, central banks have had reason to keep borrowing terms easy, the most recent and pronounced being the need to support economies that the Covid-19 pandemic had shut down. Recent high inflation caused by lingering pandemic supply constraints and surging demand – especially for workers – accentuates a needed end to accommodative policy.

Covid-19’s legacy won’t be persistently higher inflation

Higher interest rates may bring more market volatility. The segments of the global market that have benefited from low interest rates – US shares, especially the larger, fast-growing companies – reached valuations not justified by their fundamentals and now face headwinds.

But other stock market segments – such as small-cap, ‘value’ and developed markets outside the United States – appear fairly valued in a still-growing economy. Although the values of existing bonds decline as rates rise, coupons of new bonds will also pay at higher, healthier rates.

We believe that central banks will do the hard work necessary to bring inflation back towards their target levels in the years ahead. If they succeed, Covid-19’s economic legacy won’t be persistently higher inflation but rather a welcome end to an era of negative real interest rates. 


1 Laubach, Thomas, and John C. Williams, 2003. Measuring the Natural Rate of Interest. The Review of Economics and Statistics 85(4): 1063–1070. 

2 Wu, Jing Cynthia, and Fan Dora Xia, 2016. Measuring the Macroeconomic Impact of Monetary Policy at the Zero Lower Bound. Journal of Money, Credit and Banking 48 (2–3), 253–291.

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