This week, the Federal Reserve announced it would start raising rates.
In other words, the Fed has decided to wind down the ultra-supportive policy that helped the economy weather the COVID crisis.
In theory, the Fed is choosing to fight inflation by sacrificing growth just a little bit.
But to some, it still feels wrong. Hiking rates? In this economy? Why would the Fed intentionally throttle growth when the future feels so uncertain and parts of the world are at war?
The Fed may be taking short-term risks for long-term security. And while hiking rates may prove to be a good decision, it could cause some drama for you and your money.
Your wallet
If you want to understand how the Fed rate hike impacts your money, you first need to understand what rate the Fed is hiking.
On Wednesday, the Fed increased its federal funds rate, the overnight interest rate banks pay when they borrow money from each other. Increasing this rate can, in turn, impact rates on loans and savings accounts. The fed funds rate is also connected to the prime rate, the “VIP” interest rate that banks charge their most creditworthy customers (such as customers with high credit scores).
Basically, the Fed’s rate lever controls the appeal of saving versus spending. If loan rates are higher, it may be less enticing to take out a loan — like a mortgage for that house you’ve been eyeing. Conversely, if savings account rates are higher, you may think more about saving some cash versus spending or investing.
In the Fed’s eyes, more saving and less spending could help ease inflation. But this rate hike may not be an instant cure.
Loan rates have already risen in anticipation of this hike. Case in point: the average rate on a fixed 30-year mortgage has climbed to 4.5% from about 3% in September. And inflation is a complicated situation at the moment because it’s partially caused by supply chain issues and energy prices, which the Fed can’t do anything about. Spending could slow down, but the root causes may still exist.
Our economy
The Fed holds a great deal of power over the economy. And it has to make policy choices that balance job growth with stable prices. But in reality, one rate hike may not tip the scales much in either direction.
Historically, the first rate hike of a cycle typically hasn’t sparked a big selloff or pushed the economy into a recession. Only once since 1970 has the economy entered a recession less than 12 months into a rate hike cycle, and the Fed’s first few hikes haven’t preceded the start of a bear market since the 1970s. One rate hike may not make much of a difference to earnings or economic data, even if it makes you feel less excited to spend your money.
There are still lots of risks to consider, though. In a way, we’re venturing into uncharted territory with this set of rate hikes. Interest rates are historically low, the Fed’s balance sheet is bigger than ever before, and government debt is near a record high. The balancing act between inflation and growth may not be as clear-cut as Powell made it out to be. The Fed basically admitted that when it boosted its inflation forecast to 4.3% through the end of this year.
The job market may be strong, but is it durable enough to handle a barrage of hikes as the Fed fights inflation at all costs?
And in the past, the Fed has run into trouble when it’s raised rates quickly and dramatically. In 1980, the Fed tried to combat surging inflation by hiking nine times in nine months, but it couldn’t prevent the economy from slipping into a four-month recession.
From a data perspective, the economy looks like it has enough cushion in consumer demand to absorb slowing growth. But we may not know the tipping point until it’s too late.
Your portfolio
Powell and the market may be seeing eye-to-eye now. Both parties want to get inflation under control, and they seem to agree that the economy can handle more aggressive policy. Right now, the Fed funds futures market is pricing in a 100% chance of seven rate hikes this year, in line with what Fed members are expecting. Besides, investors were searching for some clarity on rate hikes, and based on the market’s reaction, they got what they were looking for.
Don’t let Wednesday’s rally fool you, though. Powell insisted that the Fed will fight inflation at all costs, but the market is expecting him to flinch. This may be why the tech-heavy Nasdaq 100 jumped nearly 4% on Wednesday, even as the Fed confirmed it was on track to hike rates at every meeting this year. By nature, higher rates tend to hit riskier growth stocks the hardest.
Maybe the market knows something we don’t. The Fed’s plans aren’t set in stone, and it may have to ease up on rate hikes if the world’s multitude of risks start to threaten growth. Plus, the market’s inflation expectations have dropped significantly this week, so there’s a chance the Fed may not need to go all out on rate hikes.
While the market has gone all in on the cyclical trade this year, signs of slowing growth and fewer rate hikes could spark a rotation back into tech and crypto.
For now, though, try not to get too exposed to one sector or asset class.
Your nerves
Look, we’re all human. And if you’re like me, this news cycle has pushed your emotions to the brink. It’s not easy to invest — or thrive — in a rapidly changing world.
When you’re feeling overwhelmed by change, try to sort through what’s signal and noise. If you’re a long-term investor, 99% of headlines probably won’t significantly impact your chances of reaching your goals. Rate hikes get a lot of attention, but usually they’re just little speed bumps for the economy that rarely move the market.
*Data sourced through Bloomberg. Can be made available upon request.