New Year, New Policy: Higher Rates Likely Ahead
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The economy continues to gain steam, the unemployment rate continues to fall, and inflation is rising. All of this seems to point to a recovered economy. So then why is the Federal Reserve still keeping interest rates low?
HOW WE GOT HERE
The Fed has a dual mandate of maintaining stable prices (i.e., inflation) and maximum employment. To help influence the rate of inflation and employment, the Fed has several tools – including increasing or decreasing the interest rate banks are charged for borrowing money, bank lending requirements, and asset purchases – to influence the economy and consumer behavior.
As the pandemic began and the economy started to shut down in early 2020, the Fed moved quickly to support it. In just two months, the federal funds rate (i.e., the interest rate the Fed sets for banks to lend money to each other overnight) went from over 1.5% to less than 0.25%, where it remains today. This makes the price of bank loans less expensive. Additionally, the Fed announced it would buy hundreds of billions of dollars of government bonds and mortgage bonds to help lower interest rates on longer-term borrowing.
WHERE WE ARE NOW
The support the Fed provided, along with fiscal stimulus packages, helped the economy successfully navigate the depths of the global pandemic. Now, unemployment is close to where it was before the pandemic started and inflation, as we’ve all experienced, is the highest we’ve seen in over 30 years.
While the Fed still has some concerns about the employment situation (e.g., women are under-employed as a percentage of where they were pre-pandemic), the central bank recognizes that it needs to shift its policy from a very accommodating one. To that end, the Fed already announced that it is going to slowly reduce the amount of money it spends on bonds – in a process called tapering – and it plans to stop buying bonds altogether sometime in the first half of 2022.
After the bond-buying stops, the Fed’s focus shifts to the level of interest rates. This will likely be one of the hot topics of 2022. Fed members are currently debating when and how quickly interest rates should increase in an effort to moderate the economy and slow the rate of inflation. The information they provide to the public suggests that some members want to see interest rates start to increase in 2022, and almost all members want interest rates to go up in 2023. If inflation remains elevated, pressure will grow for the Fed to raise interest rates sooner.
WHAT THIS MEANS FOR US
We’re now clearly at the start of a change in policy at the Federal Reserve. This change in policy likely means the end of historically low interest rates. Given how accommodative the Fed has been, it doesn’t seem inclined to turn the temperature of the economy from hot to cold in one quick motion. Like past rate-hike cycles, we’ll be in the warm zone for a while.
Rising rates has its pluses and minuses. On the plus side, higher interest rate levels mean we may see increases in our cash savings accounts, money market funds and other savings accounts. On the negative, rising interest rates typically send bond prices lower and create more price uncertainty for stocks.
Fortunately, our investment preference for short- to intermediate-term bonds, which are less sensitive to changes in interest rates than long-term bonds, should help reduce the impact of rising rates on our bond positions. For stocks, rising rates may translate into more stock market volatility (i.e., ups and downs in stock prices), so effective diversification will truly be our friend as rates start to rise.
As we’ve all seen multiple times over the past few decades, the Fed will influence interest rate levels to increase or decrease the overall speed of economic growth. With low unemployment and rising inflation telling us the economy may be moving too fast, it seems like the right time for the Fed to begin nudging things in a new direction.
