The Federal Reserve, Inflation and Interest Rates

Posted by John Charles Kernodle on August 12, 2022  /   Posted in Newsletter

For the second time in as many months, the Federal Reserve (the Fed) raised interest rates another 0.75%. What does this mean in practical terms? This decision moves the benchmark rate to a range of 2.25-2.5%. It reflects the minimum interest rate charged for borrowing money. Of course, the rate offered to someone seeking a loan will vary based on factors like credit history and the type of loan.

After interest rates hung around 0% for almost two decades, it’s worth discussing why these increases are happening. Second, we need to review some history so you’ve got reasonable context for how current events compare to the last era of rising interest rates in the 1970s. Finally, we’ll address why these actions should not trigger automatic changes to your financial plan.

We get it. Once again, the clickbait headlines make it challenging to understand and navigate news stories filled with many “what-if” possibilities. Let’s start with what we do know. Inflation is real, and you see it at every level of the economy. While some inflation is expected (the Fed aims for 2%/year[1]), the year-to-date number of 9.1% reflects the realities you see at the grocery store and gas station.[2] Things just cost more than they did a year ago.

We know a few reasons why inflation happens. Our present situation includes some well-documented ones. Supply chain issues related to everything from the pandemic to the war in Ukraine increased the cost of oil, housing, and even cars.[3] For example, when a shortage of computer chips hit automobile manufacturers, it slowed production, producing an unexpected increase in demand and higher prices for used cars. The cost for raw materials also went up, with inputs for agriculture increasing 12% in 2021 and at least another 6% in 2022.[4]

Labor costs continue to go up, too. With some workers taking earlier retirement and other employees showing more willingness to switch to different companies, firms need to compete. These costs add more to the bottom line. Higher wages can also mean more money going into the economy, creating more demand chasing after limited supplies, and pushing up prices.

Increasing interest rates provides the Fed with a tool to help reduce the amount of available money and slow down the economy. If the money supply decreases, in theory, demand may decrease and help ease pressure on suppliers. Suppose the supply gets more in line with demand. In that case, it may help rebalance the economy, reducing the cost of items and lowering inflation. The tricky part? Slowing things down without crashing the economy. If the anchor of interest becomes too heavy, companies could start laying off employees.

Now, let’s tackle why we shouldn’t assume we’ll repeat the 1970s stagflation (i.e., high interest rates, flat economic growth, soaring unemployment). Inflation ran wild during this period (12.3%, December 1974; 14.8%, March 1980)[5], and the Federal Reserve at the time hesitated to raise interest rates. Today, some economists are frustrated that interest rate hikes didn’t happen sooner. Still, the Fed seems to have learned the lessons of the 1970s and will remain proactive and consistent, qualities the 1970 Fed lacked.

We also need to consider U.S. employment. By 2021, businesses added 3.8 million jobs, but 3.25 million fewer people (compared to February 2020) are working.[6] According to the U.S. Chamber of Commerce, we only have 6 million prospective workers to fill 11 million job openings. What’s going on? Increased savings from unemployment and higher wages, early retirement, lack of childcare, and more people starting businesses decreased the pool of potential applicants.

With this kind of job market, we have a bigger cushion against the impact of layoffs connected to higher interest rates. Of course, it doesn’t guarantee we won’t feel a pinch in the future, but the U.S. still added 375,000 jobs/month from April to June.[7] We’re far from the worrying unemployment rates we experienced in the 1970s.

What does all of this mean for your financial plan? Our principles haven’t changed. We believe a long-term investment strategy focused on your goals will serve you well. We consider a diversified portfolio of exceptional companies to offer the best path through challenging and unpredictable periods. Over time, we adjust as needed if the fundamentals warrant it, but we do not react to headlines. We avoid the temptation to sell at market lows for the supposed “safety” of cash or to chase returns by buying “hot stocks” at market highs.

In short, we don’t let the crowd dictate our behavior. Sometimes, that’s easier said than done. I know how hard it is to ignore the sense of urgency to act in the current moment. That’s why I’m here to answer your questions, no matter how small or random you may think them. I’m here to help remind you of the things within your control: the actions that will move you closer to your goals.

[1] https://www.federalreserve.gov/faqs/economy_14400.htm

[2] https://www.cnbc.com/2022/07/13/inflation-rose-9point1percent-in-june-even-more-than-expected-as-price-pressures-intensify.html

[3] https://www.stlouisfed.org/on-the-economy/2022/mar/breaking-down-contributors-high-inflation

[4] https://www.fb.org/market-intel/analyzing-farm-inputs-the-cost-to-farm-keeps-rising

[5] https://www.csmonitor.com/Business/2022/0725/The-1970s-and-now-Inflation-an-unbalanced-economy-and-tough-choices

[6] https://www.csmonitor.com/Business/2022/0725/The-1970s-and-now-Inflation-an-unbalanced-economy-and-tough-choices

[7] https://qz.com/the-fed-to-markets-dont-expect-us-to-tell-you-what-com-1849339551


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