How Will Markets React as Inflation and Interest Rates Rise?

by James Austin

In the 1980s US inflation peaked at 15%. Home mortgages were charging double-digit interest rates. Inflation was roaring at 1 percent — per month. Paul Volcker – appointed by President Jimmy Carter in 1979 – inherited a situation not dissimilar to today. However, Volcker was steadfast in the mandate of an autonomous Fed: manage inflation – at any cost. 


By 1980 interest rates peaked at 20%. His hard-line attitude was very unpopular – it caused not one, but two recessions. However, he restored faith in the US dollar, and what followed were in hindsight boom years. From 1982 to 1992 the S&P 500 rose 207% – 20.7% per year. 


If inflation does reach similar highs, we can only hope Jerome Powell and the Fed today are as steadfast in achieving their mandate and remaining autonomous of government. Unfortunately, that doesn’t seem to be the case. In late 2018, the Fed (led by Powell) started to raise rates. Markets corrected, and the Fed immediately walked-back their recent guidance of raising rates and quantitative tightening. 


What action will the Fed take should inflation hit 15% or 20% again, is very much open to speculation. However, we do know that the Fed is seen as much less autonomous now than the days of Volcker.


Flash forward to the dotcom bubble of the early 2000s. By 2002, the market had dropped roughly -45%, and most of the companies related to ‘the new economy of the internet’ had failed. However, a few – like Amazon and Google (only incorporated in the mid 90s) – survived, and then flourished. 


At that time, inflation was around 6.5%. The Fed’s Chairman – Alan Greenspan – faced the same issues as now; to bring down inflation while the economy was still in recovery. 


Again, market commentators and politicians warned of recession. However, after initially dropping from 1.75% to 1% in 2002, interest rates rose all the way up to 5.5% over 5 years – all the while the economy growing.


In fact, while interest rates rose from the low in 2002 to the high in 2007, the market grew c. 85.5% - roughly 17% per year. 


Will we see a Volker or Greenspan style market reaction as inflation and interest rates rise? Only time will tell. However with an additional $11Tn added to the world economy in stimulus packages over the last few years, it's fair to say there will be many investors ready and waiting to 'buy the dip'.