No Pain, No Gain: The Cost of Tightening Monetary Policy

No Pain, No Gain: The Cost of Tightening Monetary Policy

October 01, 2022

“It will be a rough road ahead as we feel the brunt of new Fed policies designed to undo the damage done by policies that created our current inflation problems.”
National Federation of Independent Business (NFIB)


Author and former Harvard professor Todd Rose opens his thought-provoking book ‘The End of Average’ with an account of U.S. Air Force pilots in the late 1940s who found that they could not retain control of their jet-powered airplanes that were faster and more complicated to fly. Noncombat mishaps ranged from unintended dives and bungled landings to aircraft-obliterating fatalities. “It was a difficult time to be flying,” according to one retired airman. “You never knew if you were going to end up in the dirt.” At its worst point, seventeen pilots crashed in a single day.

At first, the military brass pinned the blame on the men in the cockpits, citing ‘pilot error’ as the most common reason in crash reports. Time and again, engineers found no defects and confirmed that the planes themselves seldom malfunctioned. Pilots, too, were perplexed as to why so many highly skilled and qualified aviators were crashing their planes. But if it wasn’t human or mechanical error, what was it? After numerous investigations ended with no answers, officials turned their attention to the design of the cockpit itself.

The problem, it turned out, was that when the army designed its first-ever cockpit in the 1920s, engineers had measured the physical dimensions of hundreds of male pilots and used this data to standardize the dimensions of the cockpit. As Rose notes, female pilots in those days were ‘never a serious consideration’.

For the next three decades, the size and shape of the seat, the distance to the pedals and stick, the height of the windshield, even the shape of the flight helmets were all built to conform to the ‘average’ dimensions of a 1926 pilot. In an effort to recalculate these averages, the Air Force in 1950 measured over 4,000 pilots on 10 physical dimensions believed to be most relevant for design. They postulated that this improved calculation of the average pilot would lead to a better-fitting cockpit and reduce the number of crashes.

That was, until Lt. Gilbert S. Daniels, who had a background in physical anthropology (a field that specializes in the anatomy of humans) was able to demonstrate that the ‘average’ airman did not exist. Out of 4,063 pilots, not a single one fit within the average range on all ten dimensions. His findings were clear: there was no such thing as an average pilot!

In the case of those plane crashes, structural mismatches between pilots’ bodies and cockpits proved to be fatal. Based on his findings, the Air Force redesigned cockpits with adjustable seats and pedals to fit each individual pilot. Once these and other design solutions were put in place, pilot performance soared, and the U.S. Air Force became the world’s predominant airpower.

Lately, Federal Reserve chair Jerome Powell and his fellow policymakers have been attempting their own tricky landing: combatting the worst inflation in 40-years by raising interest rates just enough to cool demand without stalling economic growth. This favorable outcome is what economists call a ‘soft landing,’ a term derived from the space race of the 1960s.

As any pilot will tell you, one of the most challenging aspects of flying is a safe landing. Like a pilot gently landing an airplane, it will take a skillful touch on the throttle by Fed officials to avoid an economic stall. Unfortunately for the economy, airline pilots have a lot more practice landing smoothly than central bankers, which have arguably achieved their only true soft landing in 1994-95 under the leadership of Alan Greenspan. That rareness is understandable as executing a soft landing has been likened to ‘landing in the fog on an aircraft carrier that’s in the middle of choppy seas.’

After misjudging inflation for much of last year, the Fed is now scrambling to raise interest rates from historic lows to get its benchmark rate high enough to where it slows growth and consumer demand. In September, the central bank raised its key interest rate by 0.75 percentage points, marking the fifth hike this year and the third such outsized increase in a row, bringing the federal funds rate to a range of 3%-3.25%. On average, policymakers think rates will climb to about 4.4% by the end of this year - 1% higher than officials had forecast in June. The 2023 median federal funds rate projection implies a peak rate of at least 4.6%, before it falls to 3.9% by year-end 2024.

Central banks around the world from the European Union and United Kingdom to India and other emerging markets followed suit with their own rate increases, with many of them raising rates by larger-than-expected margins. They were adamant that curbing runaway price growth was their main task at present. But so far, their actions have done little to curb the stubborn run-up in prices, with inflation remaining high in the U.S. and around the globe.

It is important to keep in mind that there are many costs associated with inflation, which is defined as a sustained and broad rise in prices of goods and services over time. It reduces the purchasing power of consumers and leads to lower levels of investment and slower economic growth. This creates dynamics that can lead to a recession, especially if the Fed has to continue raising interest rates to head off inflation even if the economy weakens further. Moreover, monetary policy works with a lag and inflation is a lagging indicator, so it may take some time for even today’s assertive steps to take effect.

While Fed officials are not explicitly predicting a recession, they are actively communicating their willingness to induce one if needed to ensure inflation comes down. Chairman Powell essentially warned workers, businesses and investors at the Jackson Hole gathering in August to brace for a bumpy ride as the sharp interest rate hikes will likely cause pain for Americans in the form of a weaker economy and job losses. In fact, many leading indicators of economic activity have already started to decelerate, making a soft landing increasingly unlikely.

Both consumer and producer prices remained elevated in August as a broad array of goods and services became more expensive, even as gas prices fell. The Consumer Price Index (CPI), which measures what consumers pay for goods and services, rose 8.3% from a year earlier, down from 8.5% in July and 9.1% in June, which was the highest inflation rate in four decades. The so-called core CPI, which strips out the more volatile food and energy prices, increased 6.3% in August from a year earlier, up markedly from the 5.9% rate in both June and July, indicating that broad price pressures strengthened (see graph above).

The Producer Price Index (PPI), which tracks average changes in the prices paid to producers of goods and services, was up 8.7% in the 12 months ended in August, a substantial pullback from the 9.8% rise in July. It was the second consecutive month that the pace of increase slowed, which was largely driven by a 12.7% tumble in the cost of gasoline. Following a 5.8% increase in July, the core PPI rose by 5.6% year-over-year in August, matching the lowest rate since June 2021 and potentially allaying fears of inflation becoming entrenched.

The PPI is often seen as an early indicator for broader inflationary trends and what consumers could potentially see at the store level as wholesale prices feed through the economy. History has shown that corporate profitability has declined when the headline PPI (8.7%) exceeded CPI (8.3%) - as it currently does. The difference indicates that producers reeling under the pressure of higher costs are unable to pass them on to consumers, thus adversely impacting their margins. Such cost pressures will likely affect businesses across the board. A strong labor market, meanwhile, is keeping wage growth at a healthy level, reflecting the possibility of a difficult-to-reverse wage-price spiral dynamic.

With third-quarter corporate earnings season set to kick off in the coming weeks, investors’ growing focus will be on how rising cost pressures and tighter monetary conditions are affecting corporate earnings and revenue growth at a time when economic growth appears to be slowing. For instance, shares of FedEx, the freight shipping giant whose performance is seen as a barometer of the broader economy’s health, plunged 21% after the company issued a bleak outlook for global shipping services, citing weakening global demand. It isn’t the only company facing these problems. Of all the companies included in the S&P 500, 240 cited the term ‘recession’ in their second-quarter earnings calls, according to FactSet.

Given the very real economic headwinds, the estimated third quarter earnings growth rate for the S&P 500 is 3.2%, its lowest rate since Q3 2020 as analysts have lowered their expectations by 6.3% since June 30. This is the largest decrease in the bottom-up EPS estimate for a quarter since the onset of the pandemic. It is notable that Wall Street analysts continue to forecast gains in corporate earnings and revenues for 2022 and 2023. It’s almost as if this year’s economic and earnings vulnerabilities hadn’t happened or won’t have consequences for profits going forward - a big ‘if’ in our opinion! RBC Global Asset Management found that S&P 500 earnings actually fell 17.7%, on average, during four prior recession periods associated with inflation shocks (1953, 1973, 1980, 1981).

Investors will also need to be alert for U.S. multinational companies that derive a considerable amount of their revenues and earnings from foreign markets. A stronger U.S. dollar diminishes the value of those companies’ foreign earnings when they are converted back into dollars, while also making their U.S.-made products more expensive in other countries’ local currencies. Dollar strength could hurt the profits of about a third of the S&P 500 companies, according to Bloomberg Intelligence.

So far this year, the U.S. dollar has appreciated by 19% against a basket of other major currencies as investors piled into the greenback to take advantage of higher interest rates here, making it the primary safe haven trade. The euro reached parity with the dollar in June for the first time since 2002, the British pound tumbled to a record low against the dollar in late September, the Japanese yen slid to a 24-year low, and China’s renminbi, which is tightly controlled, hit its weakest ever offshore trading level against the U.S. dollar. This might be welcome news if you are traveling internationally or importing foreign goods, but the rise in the value of the dollar could have wide-ranging effects on the global economy, especially in countries that face mounting dollar denominated debt as interest and debt repayments have become much more expensive in terms of their domestic currency. According to the IMF, roughly 40% of the world’s transactions are done in U.S. dollars. As a result, rapid moves in the value of the world’s most widely used currency have the potential to induce instability in other economies and contribute to higher currency and capital market volatility. The silver lining to all of this is that a strong dollar helps hold down domestic inflation by lowering the cost of imported goods. Since the U.S. is a large net importer, a 19% rise in the dollar can have a measurable impact on inflation.

Fed chair Powell has long contended that the U.S. central bank could tame rampant inflation without tipping the domestic economy into a recession. That optimism quickly evaporated, however, as inflation has proven far more persistent and difficult to root out than expected, despite the Fed’s most aggressive campaign to tighten monetary policy since 1981. “No one knows whether this process will lead to a recession, or, if so, how significant that recession would be,” Powell recently told reporters. Economic reports released over the past few months have only heightened that sense of uncertainty.

What is clear to everyone is that the U.S. economy is facing a severe slowdown and there is a very real risk of a recession. For the first time since the pandemic-induced recession in 2020, the U.S. gross domestic product (GDP) posted negative year-over-year growth for two consecutive quarters in the first half of the year, which is a widely accepted recession signal. The nation’s GDP fell 1.6% on an annualized basis in the first quarter, which was followed by another 0.6% drop in the second quarter.

The Conference Board Leading Economic Index (LEI), a forward-looking gauge designed to predict business cycle shifts including recessions, declined for a sixth straight month in August, with most of its 10 components in negative territory. Historically, such a string of declining readings has only happened when the economy was in, or nearing a recession.

Another one of the most consistent predictors of a recession, an inverted yield curve, has been flashing an ominous warning sign as well. An inverted yield curve means that yields on short-term bonds surpass those of long-term bonds – the opposite of their normal relationship since investors typically expect to get a higher rate on longer-dated bonds. Investors traditionally look at the points on the curve for the 2-year Treasury versus the 10-year Treasury to determine if it is inverted. The 2-year Treasury, which is more sensitive to changes in monetary policy, currently yields around 4.25%, or 45 basis points more than the 10-year rate of 3.8% (a basis point is 1/100 of a percentage point, or 0.01%). The metric itself is a reflection of what markets anticipate. On average, the lag between the curve inverting and the onset of a recession has been about a year, although it has been as long as six quarters and as short as two quarters.

Another threat to the nation’s economy is that the Fed’s aggressive approach to tackling inflation will lead to a meaningful rise in unemployment over the next year. One
oasis of strength the central bank had going for it was a strong job market with rising wages and unemployment near historic lows. The median FOMC forecast expects the unemployment rate to rise to 4.4% next year - up from August’s 3.7% - and to hold steady there into 2024. Assuming no change in the labor force, that number implies that an additional 1.2 million people could lose their jobs.

Their message is loud and clear: conquering inflation is proving to be much harder than expected, and the pursuit of that goal is likely to come with some collateral damage. In other words, this is not like landing a plane on a regular runway. This is more like landing a plane on a tightrope in strong crosswinds. Ladies and gentlemen, the captain has turned on the fasten seat belt sign!


Financial markets have historically not performed well during periods of monetary tightening and that is certainly the case again this year as the widespread market turmoil left few major asset classes unscathed.

After suffering their cruelest first-half in over 50 years, during which the benchmark S&P 500 index fell more than 20% from its early January high, stocks then rallied more than 17% into mid-August on ‘a leap of faith’ in the central bank’s policy maneuvering. Yet, that summer surge in stocks turned out to be a typical bear market rally - the type of false dawn that equity markets witnessed during some of history’s other downturns. Equity markets have been in a tailspin ever since policymakers delivered a third jumbo rate hike and repeatedly warned of more pain to come. The S&P 500 (-25%), Dow Jones Industrial Average (-21%) and Nasdaq Composite (-32%) all recorded their worst first nine months of a calendar year since 2002, according to Dow Jones Market Data.

Fixed income securities have historically been a safe investment for investors looking to limit risk associated with the stock market. That was until 2022 came around, which is shaping up to be the worst year by far for bonds (see graph above). With central banks aggressively ratcheting up interest rates, bond yields rose very quickly in a very short period of time. Due to the inverse relationship between bond yields and bond prices, those sharp increases in bond yields caused bond prices to decline and resulted in sizable paper losses. The Bloomberg U.S. Aggregate bond index, which largely tracks U.S. Treasuries, highly rated corporate bonds and mortgage-backed securities, was down 14%, on track for its worst year on record.

Stocks and bonds are supposed to be the ‘yin and yang’ of the investment world as fixed income securities usually provide protection to investors when stock prices fall. But not this time, as 2022 has so far proved to be a rare occasion where both stocks and bonds declined in value, giving investors few places to hide. Yet despite the negative performance so far this year, we believe that fixed income securities provide investors with some valuable advantages and have a critical role to play in a well-diversified portfolio. Higher rates mean that bonds are once again an attractive source of steady, reliable investment income and can now play a more significant role in retirement income strategies. Maturing bonds and coupon payments can be reinvested in new, higher-yielding bonds to help mitigate the impact of inflation. They can also dampen the overall volatility of a portfolio because bond prices have historically fluctuated less than stocks.

This year’s parallel stock and bond selloff further highlights the importance of portfolio diversification not only across asset classes, but within asset classes. Most importantly, when individual bonds (as opposed to bond funds) are held to maturity, a bondholder’s return is fixed regardless of interest rate fluctuations - they will receive all interest (coupon) payments, plus the face value of the bond at maturity.

As we are heading into the fourth quarter, the paths for interest rates, inflation, and corporate profits all remain uncertain, leaving investors without clear direction. Not surprisingly, investor pessimism over the short-term direction of the U.S. stock market continues to hover near record highs in the latest American Association of Individual Investors (AAII) Sentiment Survey. Bearish sentiment is at its highest level since March 5 of 2009 (note: the 2007-09 bear market ended on March 9, 2009). Historically, high bearish sentiment readings have been followed by above-average six-month returns in the S&P 500 - of course, past performance does not guarantee future results.

Managing through bear markets is one of the most challenging aspects of investing. History tells us to ignore interim volatility and stay invested in accordance with your individual risk-based asset allocation. The difficulty is in keeping your head and maintaining your risk tolerance through the volatility. We have discussed the characteristics of a bear market and provided some tips as a guide for investors in the April and July editions of our newsletter, which can be found at

It's quite natural to grow uneasy in the midst of a market downturn. If you feel as though your emotions are getting the better of you, consider talking to your Telos financial adviser to discuss the risk profile of your portfolio in light of the current market environment.

Bear markets don’t need to be a threat to your financial success. In fact, for the well prepared, they can be an opportunity to improve long-term returns. As famed value investor Shelby Davis observed: “You make most of your money in a bear market; you just don’t realize it at the time.” OCTOBER 2022