It’s an overused term, but this has truly been a Goldilocks economic environment for fixed-income markets over the past decade. The U.S. economy has been neither too hot nor too cold, allowing the Federal Reserve to maintain a set of highly accommodative monetary policies. As we look ahead to 2022, a different backdrop is likely to emerge: an economic environment both too hot and too cold.

On the bright side, the post-pandemic reopening has been generating robust gross domestic product growth as goods producers rebuild depleted inventories and consumers spend the billions they saved during the extended economic lockdown. As a result, the U.S. economy may expand roughly 6% this year.

Then again, many speed bumps have risen: parts shortages, supply-chain woes and hard-to-fill jobs requiring higher wages. All these factors are pushing inflation gauges to levels not seen in many years.

It’s not only inflation that’s of concern. These challenges are already having a clear impact on the economy. For example, IHS Markit says the auto industry could have sold five million more vehicles this year were it not for a shortage of semiconductors.

Fed Chairman Jerome Powell and his colleagues contend that the headwinds buffeting the U.S. economy stem from short-term “transitory” factors. If they’re right, a series of monetary policy changes planned for the next 12 to 18 months will be smoothly digested by fixed-income markets. If not, the shift away from monetary stimulus could prove more disruptive than the markets currently anticipate.

The new backdrop portends a possible shift from what we’ve seen since the Great Recession. Since that era, the personal consumption expenditures price index (PCE), the Fed’s preferred inflation gauge, has largely remained below the Fed’s target goal of 2%. As a result, “we’ve seen a long period of extremely accommodative global central bank policies,” says Fran Rodilosso, the head of fixed-income ETF portfolio management at VanEck. “The Fed and other central banks have tried to stimulate inflation but have failed and have kept upping the ante in ways never before seen as a series of drastic measures proved insufficient to meet their targets.”

These days, signs of inflation are everywhere you look. Prices for durable goods, commodities and groceries are all on the rise. According to J.D. Power, the average new vehicle cost 19% more in September than it did a year earlier, largely because automakers are focusing their production efforts on the highest-margin vehicles.

In fact, the PCE index has been above 4% in recent months, levels not seen in 30 years, leading to questions about the Fed’s go-slow approach toward a more neutral monetary backdrop. The shift away from quantitative easing means a reduction in bond buying in the coming months, and QE will reach its outright end in the middle of 2022, at which point the Fed’s set of benchmark short-term interest rates are expected to start moving higher.

Kelly Ye, director of research at IndexIQ, says “the Fed’s tone has evolved. Their main themes had been aimed at price stability and maximizing employment. … Now, they remain more squarely focused on maximizing employment.”

Still, she shares Fed chairman Powell’s view that “transitory inflation trends will steadily taper,” she says, noting that “implied forward [interest] rates remain quite stable.”

Rodilosso thinks bond investors have built great faith in the Fed, given longer-term interest rates (such as the yield on 10-year Treasurys), which are only slightly above all-time lows. “The Fed has managed to exert control over the entire yield curve until now [through accommodative policies], but it’s fair to wonder if they can as easily manage the other side of the easing process,” he says.

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