The Fed Did It – Week In Review

The Fed did it and raised interest rates in March 2022 for the first time since 2018. Investors expected this action. However, this change and the hawkish statements from the Fed and Chairman Jerome Powell have implications from investors.

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The US Federal Reserve voted to approve a 0.25% increase to the federal funds rate. Specifically, the Federal Open Market Committee (FOMC) directed the Open Market Desk at the Federal Reserve Bank of New York to,

Undertake open market operations as necessary to maintain the federal funds rate in a target range of 1/4 to 1/2 percent.

The Fed also had five other items in the directive related to its US Treasury and Mortgage-Backed Securities (MBS) holdings. First, the Fed has completed its tapering operations, meaning it is no longer adding to the balance sheet. Instead, the Fed is rolling over and reinvesting all principal payments.

Indicators of economic activity and employment have continued to strengthen. Job gains have been strong in recent months, and the unemployment rate has declined substantially. Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures.

The invasion of Ukraine by Russia is causing tremendous human and economic hardship. The implications for the US economy are highly uncertain, but in the near term, the invasion and related events are likely to create additional upward pressure on inflation and weigh on economic activity.

The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. With appropriate firming in the stance of monetary policy, the Committee expects inflation to return to its 2 percent objective and the labor market to remain strong.

The bottom line is the Fed views inflation as high, it may get higher, and they are going to change monetary policy to bring inflation back to 2%.

Why Did the Fed Increase Interest Rates?

The US Federal Reserve is increasing interest rates because of inflation. The Fed has a dual mandate: maximum employment and low and stable inflation. Unemployment has been near a record low in the past 20-years at 3.8%. Furthermore, jobless claims are at just 187,000, the lowest since 1969.

Source: St. Louis Fed

On the other hand, inflation is rising in 2022 and at 7.9%, is at a 40-year high. Moreover, the inflation rate was even higher in some regions of the US due to drought and labor shortages. However, this is not unique to the US; inflation is high in other countries worldwide. For instance, Canada’s inflation rate is at a 30-year high.

Source: US Bureau of Labor Statistics

Inflation has proven to be stubbornly high as the impact of the COVID-19 pandemic, supply chain issues, and now the war in Ukraine disrupt global trade and economies.

Since unemployment is low and inflation is high, the Fed did it and increased interest rates.

What Happens When the Fed Raises Interest Rates?

Investors are likely worried about what happens when the US Federal Reserve raises interest rates. The bottom line is that the cost of borrowing money increases. The Federal Funds target rate does not directly impact consumers and businesses. However, it does directly impact banks. Banks borrow overnight loans from the Fed to meet liquidity requirements. 

Borrowing is More Expensive

Since banks are now borrowing money at a higher rate, they will loan money out at a higher rate. The rule of thumb since 1994 for the prime rate is the Federal Funds target rate + 3.5%. The prime rate impacts auto loans, mortgage rates, credit cards, etc. Loans that had interest rates of 3.75% are now about 4%.

Savings Accounts Earn More

On the flip side, higher interest rates are good for savers. Short-term investments like high yield savings accounts, certificates of deposit (CDs), and money market deposit accounts (MMDAs) will have incrementally higher interest rates. I Bonds also will earn higher rates.

Impact on Stocks

Stocks tend to decline in anticipation of higher interest rates; this is especially true of tech stocks. The Fed started tapering in October 2021 and signaling potential rate hikes in 2022. Tech stock prices plunged in response.

Markets are anticipating costs will rise for businesses since loans are more expensive.

Bonds are Punished

Bonds are severely punished in a rising interest rate environment. The interest rates on bonds are inversely related to bond prices. If interest rates rise, bond prices decline, and vice versa. Current bonds pay a lower interest rate than newer bonds, and thus their price must drop to pay a higher interest rate.

According to StockRover, long-term US Treasuries and corporate bonds have the worst performance of all asset classes.

Source: StockRover

Final Thoughts on The Fed Did It

Investors should be aware that the Fed is bringing its tools to bear to reduce inflation. First, the US Federal Reserve has completed tapering and is no longer buying bonds. Then, after much anticipation, the Fed went ahead and did it and increased interest rates for the first time since 2018, and another hike is likely to be implemented in the next FOMC meeting. Next, the Fed is going to reduce its balance sheet.

This change will probably cause volatility in the stock and bond markets. So, investors should be prepared for a bumpy ride.