Mar 21, 2022 - Interest Rates, Inflation, and Investment Strategy Part 1: Understanding Interest Rates
At its March 15–16 Federal Open Market Committee (FOMC) meeting, the U.S. Federal Reserve raised its federal target funds rate by a quarter point. It was the first increase since December 2018, but it wasn’t a huge surprise. Fed Chair Jerome Powell had already said we should expect as much, with the potential for additional hikes before year-end.
Along with interest rates, inflation remains a related topic of conversation … not to mention the economic toll and humanitarian tragedy being wrought by Russia’s horrific warmongering.
To our distress, there is only so much we can do to alleviate the heartbreaking news coming out of Ukraine. But as a financial advisor, we can at least help you put these interrelated influences into thoughtful context. That’s what we’ll focus on in this multipart series. We’ll start with interest rates, followed by inflation, and wrap by exploring what these influences mean to you and your investments.
To steal our own thunder, this series will reinforce the core principles we already incorporate as we help people navigate their financial interests across time and through various market conditions. The news may be new, but the timeless tenets driving our patient and personalized advice are enduring and, if anything, even more relevant during periods of increased uncertainty.
What’s Up With the Fed Rate?
Almost everyone is familiar with interest rates. That said, far fewer know what to make of the Fed’s target funds rate in particular. Everyone from economists, to politicians, to the financial press seems to always be talking about them. Markets rise or fall when the Fed comments on them. They’re often treated as synonymous with interest rates in general. They must be important, right?
Well, yes, the target funds rate is important. But not in the way you might expect.
As the central bank for the United States, the Federal Reserve is tasked with setting monetary policy to promote “maximum employment, stable prices and moderate long-term interest rates … thereby supporting conditions for long-term economic growth.” In this supporting role, the Fed uses its target funds rate as one of many “levers” to achieve its aims.
When the Fed increases or decreases the target funds rate by specific points—such as the recent 0.25% increase—it’s actually establishing a range of rates. Current rates are thus 0.25%–0.50%, up a quarter-point from 0.00%–0.25%. Banks and similar institutions then target this range when they lend overnight money to one another. They use these hyper-short-term loans to collectively maintain their required cash reserves, or to otherwise raise immediate operational cash.
Keeping Time With the Fed
Think of the banking system as an intricate timepiece. Each bank operates independently. Each can choose when or if to lend to or borrow from other banks within the Fed’s current target rate range. Each also sets its own, public-facing retail rates. When banks stay in synch with one another and the Fed, the economy will hopefully keep good time. But if even a few cogs get jammed, it can stymie the entire operation.
In our analogy, the Fed plays the role of a master timekeeper. Or at least it tries to.
When the Fed increases the target funds rate (as it just did): It’s hoping to reduce the flow of excess cash or stimulus in the economy, which in turn can help temper inflation.
When the Fed lowers the target funds rate (as it did during the pandemic and the Great Recession): It’s hoping to keep stimulating cash flowing through the economy … without letting inflation get out of hand.
Along with adjusting the target funds rate: The Fed also can inject or extract cash into or out of the system, in an effort to quicken or slow the wheels of commerce, increase or decrease inflation, ward off a recession, tamp down “irrational exuberance,” and/or otherwise spur or check economic activities.
However, we must emphasize: No single entity can just flip a switch to power the economy off and on. The Fed is in a relatively strong position to encourage long-term economic growth through its actions. Often, its actions will trickle down to other types of loans and move them in a similar direction, for the same purpose. But not always, and rarely across the board. As in any complex system, any given move interacts with countless others, with varied results. This is especially so globally, as most countries have central banks and “timekeepers” of their own.
Which brings us to our next point.
The Fed Rate Isn’t Every Rate
To review, the Fed’s target funds rate is the rate range at which banks lend each other overnight cash. Rising rates are meant to help unwind earlier stimulus programs, and manage rising inflation by tinkering with the cash flow in our banking systems. But as an admittedly blunt tool, there is an even more tenuous connection between the Fed’s rates and the interest rates you personally pay or receive.
For example, as described in this Wall Street Journal video, existing fixed-rate debt such as home and student loans may not be as immediately affected by rising rates, while free-floating credit card debt is more likely to creep quickly upward in tandem with the Fed’s rates. It’s generally wise to avoid credit card debt to begin with, given their persistently higher rates. It’s even more critical as rates rise.
Similarly, you may or may not receive higher rates on interest-bearing instruments such as bonds, CDs, bank accounts, etc. That’s because it’s the banks and similar entities, not the Fed, who set these rates.
We’ll discuss this further in part 3, when we explore the impact of interest rates and inflation on your investment strategies. But as another recent Wall Street Journal column described: “Interest rates are about to rise. Savers shouldn’t get their hopes up. … Banks have little incentive to raise the interest they pay on deposits because they simply don’t need the money.”
Next Up: Inflation
Time will tell whether this or future Fed rate increases contribute to lower inflation and a healthy economy. Similar actions have been known to help in the past. But of course, each era comes with its own challenges and opportunities. Current events are certainly no exception to this rule! In particular, current global strife may well have a much larger influence on inflationary risk than what the Fed can and cannot do about interest rates. Next up, we’ll talk about inflation, and how it factors into our conversation so far.