Higher lending rates were the primary driver of the index recently moving into restrictive territory. The Fed and the markets both initially expected the rise in consumer prices in the wake of the COVID-19 pandemic to be transitory. Although unflattering year-over-year comparisons have faded, persistent supply chain bottlenecks, widespread labor shortages, and rising food prices have helped push consumer prices higher.
Energy prices have contributed, too. While the price of oil started on an upward trajectory in late 2020 alongside the rollout of vaccines and a brighter growth outlook, it has jumped roughly 70% from the beginning of 2022 through early March, although it has since given back some of those gains.
Together, these forces drove up the Consumer Price Index. It surged to 8.6% on an annualized basis in May, a level not seen since 1981.
The Fed’s pivot toward less accommodative monetary policy contributed to the rise in lending rates. In November 2021, the Fed started to taper its monthly bond purchases. In March 2022, it made its first short-term interest rate hike, significantly raising market-based expectations about the future path of Fed monetary policy. And in April, it unveiled a preliminary schedule for reducing its balance sheet. As price stability is one of its mandates, we believe the Fed will continue to do the hard work necessary to bring inflation back toward target levels.
Equity valuations took a hit with Russia invading Ukraine, adding to the tightening of financial conditions. As of the end of May, the broad U.S. stock market was down about 14% year to date.
It’s worth noting that equity valuations are one of the more volatile components in our VFCI as they can fluctuate significantly over even a short period of time. As Vanguard economist Adam Schickling notes, “Periods of tightening driven exclusively by equity events can often be short-lived, but all indicators have been moving in the same direction recently, which is historically a sign that the current tightening may be more likely to persist.”