Their decisions are always scrutinized by investors, particularly at such a crucial moment when the U.S. economy is facing a dual threat of runaway inflation and economic recession.
Increasing rates slows economic growth, allowing supply to catch up with demand to tackle inflation.
With persisting above-target inflation, the decision to raise rates for the sixth consecutive session was no surprise. But considerable speculation exists about the next move by the Fed, and how long interest rates remain high.
The market context
Despite raising rates at every meeting since March, U.S. inflation remains stubbornly high at 8.2%, particularly for food and energy prices.[1]
There are some positive signs that the effects of the war in Ukraine on global trade in commodities are beginning to stabilize and supply chains are returning to normal. Agricultural commodity prices have returned to pre-conflict levels,[2] and the prices of other goods such as lumber[3] and steel[4] have also fallen drastically.
But as long as critical goods such as oil and natural gas remain constrained, inflation remains a threat.
U.S. unemployment of 3.7% is low in historical terms and payroll data suggest that demand for labor is growing.[5] This is likely to reinforce rising prices as wage growth fuels price increases.
The Fed strategy & outlook
The increase in the target rate to a range of 3.75 to 4.0% represents the fourth 0.75% hike this year.
Fed Chair Jerome Powell hinted that the pace of rate rises might diminish,[6] but the “ultimate” rate might be higher than expected. The move in bond prices implies that the former ceiling of 4.6% indicated in the September meeting may have risen to 5% or more.[7]
The nuanced outlook between “hawkish” and ”dovish” reflects that rate movements will depend on events outside the control of the Fed.
Also, the impact of the previous rate increases remains to be seen. Typically, it takes six to 12 months for a rate change to show an observable impact.[8] By the December or February meeting, the Fed may have greater visibility on the intervention required.
Implications for investors
Given the precarious short-term outlook for the U.S. economy, the cautious, nuanced attitude of the Fed appears appropriate and should bring some comfort to investors.
Taming inflation is important for the economy, but avoiding recession is equally important. Maintaining higher interest rates longer than necessary may lead to economic stagnation or a sharp downturn.
Higher interest rates have a particularly profound impact on stocks. First, they increase the cost of capital, making the shares less valuable. Second, they increase the cost of debt, reducing corporate earnings. Third, investors transfer capital to attractively price bonds.
The future of the Fed rate will become clearer as labor and inflation figures emerge over the coming months. Meanwhile, investors should remain vigilant, and take advantage of opportunities as they arise with the help of their financial advisers.
[1] Forbes - https://www.forbes.com/advisor/investing/why-is-inflation-rising-right-now/
[2] UN - https://www.un.org/development/desa/dpad/publication/world-economic-situation-and-prospects-november-2022-briefing-no-166/
[3] Markets Insider - https://markets.businessinsider.com/news/commodities/lumber-prices-new-low-housing-market-warning-mortgage-rates-goldman-2022-8
[4] Fastmarkets - https://www.fastmarkets.com/insights/six-months-of-war-how-has-it-changed-the-global-steel-market
[5] Bureau of Labor Statistics - https://www.bls.gov/news.release/pdf/empsit.pdf
[6] CNBC - https://youtu.be/ZMzoCuh-Fhg
[7] Economist - https://www.economist.com/finance-and-economics/2022/11/02/the-fed-delivers-another-jumbo-rate-rise-and-its-far-from-done
[8] US Bank - https://www.usbank.com/investing/financial-perspectives/market-news/federal-reserve-tapering-asset-purchases.html