The Federal Reserve (the Fed) unusually increased interest rates by 50 basis points, or 0.5%, on May 4. Normally, the Fed moves in precise 0.25% stages while raising interest rates (commonly known as “tightening policy”). In reality, this action ends a run of 26 consecutive rate increases of precisely 0.25%. In May 2000, they last increased rates by more than 0.25% all at once.
Why is the Fed making such a strange choice? Inflation is the simple solution. The Fed is now aware that they are behind the curve, which is the clearer response. The Fed needs to catch up because inflation is currently at a 40-year high and is substantially higher than they anticipated only a few months ago.
For the past several months, the Fed, interest rates, and inflation have all contributed to the volatility of the financial markets. These factors may continue to have a significant impact on markets in the future. What you need to know about inflation, the Fed’s response to it, and how it affects you and your money is provided below.
Interest rates, the Federal Reserve, and inflation
The Fed’s duty is to maintain low rates of both unemployment and inflation. The Fed’s primary instrument for achieving this is the current level of interest rates. They utilize this technique, in its most basic and generic form, to stop the economy from getting too hot or too cold.
By lowering interest rates (or “loosening” policy), they facilitate economic growth by making borrowing more affordable. When interest rates were lowered to zero at the start of the pandemic recession in 2020, that was the goal. They’ll take the opposite action and raise rates (or “tighten” policy) when the economy is booming or inflation starts to worry people.
What effects do rate increases have on the economy specifically, and how might they lower inflation? When supply cannot keep up with demand, inflation results. While the Fed’s fluctuating interest rates have little effect on supply, they can have a very strong impact on demand. Therefore, the only method for the Fed to control inflation is to reduce demand from both consumers and companies by raising the cost of borrowing money.
Since businesses frequently borrow money for capital projects (such as the construction of new facilities or the purchase of new equipment), higher borrowing costs will likely slow down this activity and serve to restrain inflation.
How Did Inflation Initially Rise to Such High Levels?
According to the most recent Consumer Price Index report, prices increased by 8.5% over the previous year, the highest yearly increase since 1982. Where did we come from?
When people have the ability and want to purchase more goods than the economy can create and provide, we can think of inflation as the result. All four of those words—ability, want, produce, and deliver—were essential to how inflation increased throughout this pandemic recovery.
The federal government’s stimulus payments were what first enabled Americans to spend more. The labor market was still incredibly robust even after the stimulus program ended, which made it possible for wage growth to continue where it had left off. In 2021, when the economy began to recover, consumer spending really took off. This included some previously unmet demand for services like travel. However, consumer expenditure on products also continues to be high. Consumer spending on products as of March 2022 is 29% more than in 2019.
The supply chain faced some difficulties as a result of things like industrial closures. The auto industry felt the effects of this most strongly. In addition, there have been ongoing issues with labor shortages in every sector of the American economy, including for factory employees, truck drivers, and warehouse workers. When you combine this with exceptionally high demand, particularly for physical products, the economy finds it difficult to manufacture and/or deliver the goods that consumers want to purchase.
When there is a high demand for a product, businesses typically decide to sell more of it to boost profits. However, they hike prices when they can’t actually produce more. This appears to be the precise circumstance we are facing right now.
Why is the Fed lagging behind?
Why the Fed waited until now to go more aggressive in combating inflation is a reasonable issue. Let’s not forget what an odd economic cycle this has been, and give the Fed a little leeway. In the spring of 2020, as soon as the pandemic started, unemployment shot up to levels last seen during the Great Depression. With the Fed lowering rates and the government cutting stimulus cheques, Congress and the Fed made an effort to use every instrument at their disposal to battle this downturn.
It was simple to write off inflation when it initially began to increase in the spring of 2021 as the result of transient forces. A relatively small number of items, all of which looked to be primarily pandemic-related, were driving inflation. For instance, the three main pricing factors were airfare, lodging, and rental vehicles. That appeared to be a result of unmet travel and leisure demand. People used those March 2021 stimulus payments to pay for a June getaway. But surely that impact would ebb and flow?
The strength of the labor market was something the Fed did not wager on. Although the Fed anticipated that household incomes would decrease as the effects of the stimulus wore off, growing wages instead allowed consumer spending to stay far above pre-pandemic levels with no visible signs of slowing.
Therefore, the Fed’s initial assumption that the inflation problem would resolve itself was not unreasonable. Now, though, we can see that it will be a challenging issue to tackle. As long as consumer spending stays this high, inflation will likely continue high. As long as household income increases at this rate, consumer spending will continue to be high. Wage growth is the key driver of household income, and it will continue to be high as long as the labor market remains this tight.
For comparison, the last time inflation was this high was in the 1970s, when the economy and market were significantly different. At that time, heavy industry, producers of commodities, and utilities dominated the U.S. stock market. These businesses are affected by inflation in a totally different way than modern behemoths like Apple and Amazon. Furthermore, even if the Fed is currently lagging behind, it has already taken far greater initiative this time around. Before the Fed became serious about battling inflation in the 1970s, it had been running high for almost ten years.
What Affect Will Increasing Interest Rates Have on You and Your Money?
Higher interest rates could ultimately affect you and your finances in a variety of ways. The ability to make large purchases, your ability to save for short-term goals, and your long-term investing strategy can all be impacted by increasing interest rates.
Short-term goal savings: As long as interest rates are rising, you should be earning more interest on your savings accounts. For goals that are within the next two to three years, you should choose savings accounts with the best rates (such high yield savings accounts), and you might want to think about investing in I bonds for objectives that are a year or more away.
Ability to make significant purchases: As interest rates rise, borrowing costs increase, making large purchases like a home, car, or college more expensive. On the other hand, increasing rates should (emphasis on should) tame the ferocious growth in home and vehicle prices. Look to save a little extra money for a down payment when buying a home or car. The smaller your loan and the less interest you pay, the more money you can put down up front. Second, you might find it useful to reevaluate your goal buying price.
Long-term investing strategy: Generally speaking, you may not need to alter your investing strategy. Although market volatility is a regular aspect of investment, it is expected to remain elevated (see market context below). There is no risk-free, high-return investment, but you may change the amount of risk in your portfolio if certain levels of chronic volatility worry you.
It’s likely that financial markets have already experienced the effects of inflation. Keep in mind that markets are forward-looking, which means that the cost of a stock or bond takes into account what everyone anticipates will occur in the future. Since everyone is aware of how high inflation is, this information is somewhat priced into the markets.
Why therefore is volatility expected to persist? This is due in part to the possibility that the Fed may raise interest rates excessively quickly and create a recession. It may be alluring to attempt to exit the stock market in the event that a recession really materializes in the hopes of sparing yourself extra suffering, but doing so presents a significant risk because it is very difficult to predict when a recession will start. During an economic upswing, there are numerous recession head-fakes. There were at least three such head-fakes during the post-2008 expansion: in 2011, 2016, and 2018. In every instance, equities saw a brief but severe decline before roaring back once it was evident the economy was still robust.
By comparing the typical investor’s performance to the S&P 500 across various time periods, we can illustrate how harmful market timing may be. You may think of this as contrasting the results of someone who follows their plan and stays invested with those of someone who tries to timing market entry and exits:
To illustrate this concept, consider that over the course of 30 years, $10,000 would have grown to $78,947 if you had earned the same 7.13% return as the aforementioned “typical equity fund investor.” Your return would have been 10.65% and you would have ended up with $208,230 if you had decided to stay invested.
The message is really obvious. The ideal approach to investing, particularly during times of volatility or market declines, is to take a disciplined approach. How we act matters far more than how interest rates, inflation, or the markets act. Focusing on the factors we can influence and discounting the factors we cannot is the secret to achieving better long-term investment results. We can control important financial choices that give us power over the kind of life we want to live, even though we have no control over things like inflation, the rate at which the Fed rises interest rates, or what happens to the markets as a result. We have control over things like how much money we invest, the fees we pay, how we handle taxes, how we handle and control risk, and how we adapt our approach over time as our circumstances and our objectives change.
A CFP® Professional at Facet Wealth can assist you in understanding how inflation and increasing interest rates will affect your finances and in creating a dynamic financial plan that adapts as your life and the environment change.