It’s been a while since we’ve seen this, but the Federal Reserve is gearing up to raise interest rates. What does that mean for investors, borrowers, spenders and the economy as a whole?
Last Round of Rate Increases
My memory was hazy on this, so I had to do some research. The last time the Board of Governors of the Federal Reserve System in the US (“the Fed”) decided to raise their target federal funds rate was in December 2018. At that time, it was increased to 2.25% – 2.50% up just a quarter point. The federal funds rate is the rate banks charge each other to borrow. Those of you who read our blog on inflation last summer know the reason this is important is that the Federal Reserve will use the Fed Funds rate as a tool to decrease or increase economic growth. Back in 2018, the economy was doing seemingly well. Unemployment was relatively modest and inflation was 2.4% – just a bit above the target level of the Federal Reserve 2% at the time.
Things changed shortly thereafter. The Fed cut rates three times in 2019 (long before the COVID pandemic) in an attempt to stimulate the economy and increase inflation which had dropped to 1.8%. Imagine that, trying to bring on inflation. Then came the pandemic and several rate cuts by the Fed initiated to help spur the economy. That leaves us where we are today, with a 0.0% – 0.25% federal funds rate target.
What’s the Point in Raising Interest Rates?
If you guessed inflation, pat yourself on the back. It’s been nearly impossible not to notice the increase in consumer prices lately. The Consumer Price Index (CPI) from December 2020 to December 2021 rose 7%. The Federal Reserve, with its Congress imposed mandate of maximum employment and stable prices, has to do something. It is widely expected that the Fed will raise rates a quarter point at their March meeting and then two more times later in the year. The desired effect is to cause borrowing rates to increase across the country. Higher rates on mortgages, vehicle loans and business loans, it is hoped, would tamp down demand for products. Less demand should result in lower prices and a return to normal inflation which would make the Fed happy.
Will Higher Interest Rates Actually Fix the Inflation Problem?
Basic economic theory tells us that market prices are determined by both supply and demand. The Fed will attempt to address inflated prices by affecting market demand. But, what about the supply side of the problem? Supply chain issues that emerged with the start of the COVID pandemic two years ago are still with us. Raising interest rates won’t address semi-conductor chip shortages or shipping delays. Perhaps, slowing demand for products would allow suppliers to catch up over time, but it seems that the most important factor will be the course of the pandemic. If world-wide pandemic conditions improve to the point that suppliers can ramp up production levels, then the supply-demand imbalance may be corrected. That, combined with slowing demand, could bring inflation back down to the 2.5% range.
What We are Watching
Bond market prices have already adjusted downward with higher inflation numbers beginning last year (a fixed income asset falls in value when the income it produces buys less). Stock market values have also adjusted to the expectation of rising interest rates as seen in the recent market index drops. Stocks prices are sensitive to threats to economic growth and corporate earnings such as rising interest rates that could slow the economy. In the short-run, overall bond prices will decline in response to higher market rates. However, over the long-run, bond holders may benefit from higher dividend rates, provided inflation comes back down.
What we and many others will be watching carefully is the trajectory of inflation as the year progresses and interest rates are hiked. What if inflation does not abate after the first couple rate hikes? Will the Fed raise rates more aggressively than expected to slow demand and the economy more quickly? The stock market would respond negatively to that. Maybe inflation will start to wane as supply chain issues improve and the Fed will skip a rate increase later in the year. That could be positive for stock prices this year.
We will be watching with great interest that tightrope act by the Fed in 2022.
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Any opinions are those of David Werle, CFP®, CSRIC™ and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. This material is being provided for information purposes only. Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional.
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