To appreciate the strength of the economic recovery from the sharp Covid-19 recession in 2020, look no further than the labour markets. Unemployment rates around the world have fallen toward pre-pandemic lows.

In economies such as the United States and United Kingdom, many firms are suffering from labour shortages. Fewer workers are participating in the labour force than before the pandemic, and the higher wages they can secure as employers compete for them threaten to take already accelerating inflation to a new, more worrisome level. Wage inflation is “sticky”. Although it takes time for wages to climb in tandem with broader prices, when they do, they’re fully along for the ride and ready to jump into the driver’s seat.

Central banks have underestimated this strength in labour markets and the growing wage pressures. In my view, markets are underestimating the degree to which central banks will need to use their powerful tools to pull inflation back to acceptable levels.

Higher rates are in the US economy’s best interest. Vanguard believes that the Federal Reserve (Fed) may need to raise its target for short-term interest rates to 3% from its current range of 0%–0.25%. That would require steady rate hikes over the next few years, to a degree that markets haven’t priced in beyond 2022.

In the UK, the Bank of England became the first major central bank to begin raising interest rates in the Covid-19 era, when it lifted its benchmark rate to 0.25% from 0.1% in December. We expect a second hike in the Bank Rate to 0.5%, probably at its next monetary policy committee meeting on 3 February.

Why higher rates can be a good thing

Bond investors should welcome the prospect of higher interest rates. Although rising rates may produce modest negative returns for a time, they’re a long-term positive. Investors with a longer horizon than their portfolio’s duration stand to benefit, as higher yields on reinvested cash flow outweigh the market price decline.¹ Raising short-term rates should also forestall a rise in long-term bond yields because expectations of future inflation should not rise further.

Equity investors may feel less hopeful, and that’s understandable. In recent years they’ve come to enjoy some heady returns, fuelled by negative after-inflation interest rates. The removal of such stimulus as central banks address inflation suggests turbulence ahead.

But negative real interest rates and the higher equity valuations they’ve promoted have come at a cost of future returns. That’s why our long-term outlook for equities, as we discuss in the Vanguard economic and market outlook for 2022, is so guarded.

That doesn’t mean anything needs to change in your portfolio. Lower return expectations should not be a reason to take bigger risks with your savings. If you’ve chosen the ratio of bonds and shares in your portfolio to match your personal goals and tolerance for risk, then your best option may be to stay the course.

You may be able to partly offset the impact of a low-return environment by making sure you are investing in low-cost products. Saving more can also increase your chances of achieving your goals.

We continue to believe that holding a globally diversified portfolio and taking a long-term perspective will give investors the best chance of investment success in 2022 and beyond.

Extending the growth cycle

Our economic and market outlook for 2022 acknowledges the challenges that policymakers face in removing monetary and fiscal support that propped up economies during an unprecedented crisis. Surging inflation won’t come down magically. The path for central banks is clear.

Accelerating inflation is a threat to economies that otherwise remain fundamentally sound. Raising interest rates to subdue it should extend the growth cycle, not shorten it.

 

¹ Duration is a measure of bond prices’ sensitivity to a change in interest rates.