The Federal Reserve Raises Interest Rates

After pursuing an easy money policy for years, the Federal Reserve (Fed) has finally made a change.  A recent statement announced four essential moves:

  1. The Fed would end its program of adding liquidity to markets in which it directly bought securities –– what policy makers call “quantitative easing.”
  2. It has raised the rate on the benchmark federal funds rate by one-quarter of a percentage point to 0.5 percent.
  3. It has promised more interest rate increases in coming months.
  4. It hinted that it might reverse its quantitative easing program and  begin to sell from the enormous hoard of securities it amassed during the years of quantitative easing.

This is a big change and is aimed at directly countering the growing U.S. inflationary momentum that has built over the last 12-18 months.  At the end of 2020, consumer price inflation averaged about 2.5 percent a year.  As of the latest measure, it was running at some 8 percent a year.  The Fed has an obligation to resist this trend.  Its charter demands it, and for good reason, because accelerating prices are extremely destructive to the economy and to financial markets:

  1. Accelerating prices make workingmen and women poorer by eroding the buying power of their paychecks.  Even when workers win pay increases, they lose by having to play a constant game of catchup.
  2. They create uncertainty among business decision-makers and thereby curtail productive investments that would otherwise add value to companies and also enable pay increases by increasing worker output per hour.
  3. Because they muddle the real value of things and activities, rapidly rising prices distort the roles of investment monies in the economy,  thus curtailing the growth of its productive ability.
  4. Rising prices, by eroding the value of the dollar, weaken the value of anything denominated in dollars, making financial assets especially vulnerable to downward valuations.  This is especially true of bonds, which pay interest stated as a fixed dollar amount and pay a fixed dollar amount in principal when they mature.

For a review of inflation’s winners and losers, see this post.

In one respect, this is a bold move by the Fed.  For many months in 2021, as inflation was building momentum, the Fed as well as administration officials dismissed concerns about the trend, saying that the price pressure was “transitory.”  Accordingly, monetary policy-makers stuck with what was a fundamentally inflationary policy posture.  The recent change is as close to an admission of error as Washington ever makes.  For those who were concerned about the ill effects of inflation, the change comes as a relief.  

There is something more.  The Fed seems to have broken with the White House.    President Biden, for obvious political reasons, has blamed rising energy prices — and by implication the overall inflation — on Russia’s Vladimir Putin and his war on Ukraine.  However, the statement accompanying the Fed’s policy shift spoke of “broader price pressures” and said outright that the price pressure fundamentally is not a result of the invasion of Ukraine.  Had the Fed gone along with the kind of reasoning broadcast by the White House, it would have fed the fear that monetary policy-makers lacked the necessary conviction to deal with inflationary pressures.  Thus, the Fed’s new, more serious characterization should inspire greater confidence that it will diligently work to ease general price pressures.

But even with the Fed’s change, there are many who see it as too little, too late.  Students of the great inflation of the 1970s and 1980s point out that those price pressures developed because of a lack of forceful counter-inflationary monetary moves, and that this absence allowed inflation to embed itself into the economy and make relief ultimately much more difficult.  Now, though they are pleased that the Fed is at last acting, they worry that it is moving too cautiously to avoid the mistakes of the past.  That was the judgment of James Bullard, president of the Federal Reserve Bank of St. Louis, who dissented from the Fed’s decision, and pressed for a larger, 0.5 percent federal funds rate increase.

No doubt monetary policy-makers opted against an aggressive rise in interest rates for fear it would cause markets to crash and perhaps bring on recession.  Though not an unreasonable concern, it would be easy to overstate it.  Certainly, markets have shown no sign of crashing in the face of the Fed’s moves.  Initially, at least, they seem to have responded with relief that the Fed was at last taking the inflationary threat seriously.  Nor does the risk of a recession look serious.  Yes, the post-pandemic economic surge is slowing, but there is little that points to outright recession or even the kinds of vulnerabilities that might give the Fed pause. 

Besides, even with the announced change one could hardly describe Fed policy as restrictive. Consider that an 8 percent inflation rate enables someone to repay borrowed funds with dollars that are worth 8 percent less in real terms than the year before.  If people borrow short term at the federal funds rate of 0.5 percent, they enjoy the use of the money for a year and effectively pay the lender far less value, after factoring in the rate of inflation, than the lender earns from the interest charged.  Indeed, current matters are such that the borrower is effectively paid in real terms to use the money, about 7.5 percent a year, in fact.  A major incentive to borrow and spend remains hardly a restrictive monetary environment.

So it seems likely that the Fed will have to make more restrictive moves sooner than it has indicated.  That would take the federal funds rate and interest rates generally above the current consensus expectation of just under 2 percent by the end of 2022 and to 2.75 percent by the end of 2023.  Such moves will hit values of stocks, and especially bonds, as the above link outlines in greater detail.  

Investors should avoid bonds that will fall in value with each interest rate hike.  For a detailed explanation look here.  With stocks, the impact is twofold.  First, they fall from the shock of interest rate increases and uncertainties about how inflation and rate increases will impact corporate profits.  But then, as business learns to cope with inflation, and/or the Fed manages to contain the inflationary pressure, stocks recover lost ground.  This prospect suggests three paths for stock investors:

  1. Those who need money soon should leave stocks and take their losses before they worsen.  Of course, as readers of these posts should know, they should not even be in the stock market if they will need the money over a short time horizon.
  2. Those who can wait for the money and are already in stocks should wait for the inevitable stock recovery.  And while selling stocks now in order to buy them cheaper later may appear attractive, it requires superhuman timing.
  3. Those who can let the money sit for a long time but who are not yet in stocks might buy in on market weakness. 

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