The new year has already begun with many events whose outcomes can affect your investments. Here is another one: the Federal Open Market Committee (FOMC) is meeting on January 25th–26th, when it will decide on monetary policy. How is this going to affect you?
Big decisions ahead
This will be the first FOMC meeting of 2022 and, when making this decision, the Fed has to bear in mind several important goals for the US economy. These include maximising employment rates, stabilising the prices of goods and determining interest rates that will be sustainable for the long term.
They achieve these goals primarily by raising or lowering interest rates, a decision which has a ripple effect throughout the economy.
How the interest rate affects employment and inflation
When the economy isn’t doing well, the Fed will usually consider lowering interest rates — as they did during the pandemic. This eventually translates into more readily available cash for people looking to borrow, as the interest on loans will be lower. Businesses have more money to expand and hire more employees. Thus, a low interest rate is considered to stimulate the economy — but up to a point.
When the Fed lowers interest rates, this not only means that borrowing is less expensive, but also that there is less of an incentive for people to save money. We like to save money when we earn high interest, and without that incentive, are more likely to spend it. More money flooding into commerce means that there is an increased demand for a limited amount of products which eventually causes prices to rise — and the dreaded higher inflation rate.
Finding an interest rate sweet spot
A delicate balance must be maintained between stimulating the economy when necessary, and pulling back when it causes problems. It is for this reason that the Fed is almost certainly expected to raise interest rates very soon — the only question is how quickly and how often.
Inflation over the past year has been much higher than expected, and certainly higher than the Fed’s target inflation rate of 2%. So, to control inflation, which is an important part of the Fed’s job, it has to raise interest rates. Indeed, we know from the summary of their last meeting (called “minutes”), there was broad agreement that interest rates must be raised.
Recent comments from members of the FOMC suggest that rates will rise in March and that there will be three rate hikes, each a quarter of a percent. Raising the interest rate too much or too quickly could result in instability for the economy and volatility in the markets, which obviously should be avoided. An incremental approach, where the Fed can closely monitor how economic conditions are affected, can help smooth the transition for the markets.
Taking it slow with tapering
The Fed will continue to reduce the amount of monthly assets it purchases until it reaches zero. This is called tapering assets. It is a process the Fed began in November at $15 billion monthly, but now it has doubled the amount, reducing its purchases by $30 billion monthly. Asset purchases are expected to reach zero by March, and then interest rates are expected to rise.
The reason for the delay is that as long as the Fed is purchasing assets, it is increasing the amount of money in circulation. More money floating around means more inflation. So, it would be counterproductive for the Fed to continue policies that increase inflation and simultaneously implement policies to decrease inflation.
What about my stocks?
What investors want to know is how a rise in interest rates will affect their portfolios. It seems likely that 2022 will be volatile due to several factors, one of which is the inevitability of a rise in interest rates. Exactly how much, how often and when remains in the air.
A look to history, however, indicates that in the first months following a rate hike, stocks are negatively affected — but then they rebound within six months to a year. Allowed enough time, markets inevitably returned to balance.
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