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MARK-TO-MARKET: Federal Reserve kicks rate hikes into high gear

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In most years, discussions of the latest Federal Reserve policy decisions are left to the realm of economists and Wall Street traders and analysts. Rarely is it the topic of conversation at bars, football tailgate parties or family get-togethers. To do so was to risk banishment for future events — your name permanently inscribed on the dreaded “do not call” list. But the Fed has now been thrust into the national spotlight, and dialogue, as it tries to grapple with a 40-year high level of inflation.

As part of its mandate, the Federal Reserve drives our nation’s monetary policy. One of the main tools in this endeavor is the management of the fed funds rate, which serves as the benchmark for short-term interest rates. Through the management of interest rates, the Fed seeks to manipulate spending, investment and inflation to promote the health and stability of our economy.

First, some history. Back in March and April 2020, the Fed slashed the fed funds rate from 1.75% to near-0% in response to the global pandemic. The goal was that ultra-low interest rates, combined with massive amounts of government stimulus spending, would artificially boost demand for goods and services and thus help stimulate economic growth.

But things have quickly spiraled out of control. Massive stimulus spending and a highly accommodative Fed monetary policy poured a virtual mountain of new money into the U.S. economy. How much, you might ask? Well, there’s currently 42% more U.S. dollars circulating in the economy than there was in February 2020, before the pandemic.

That’s a lot of new money. And what do people tend to do with all that extra cash? They spend it. Moreover, the ongoing labor shortage and supply-chain issues have severely limited the manufacture and production of goods. American consumers, flush with extra cash, chasing a limited quantity of goods and services is a high-octane recipe for inflation. Two weeks ago, the latest inflation number was reported at 8.6%, a new 40-year high dating back to 1981.

The fed funds rate stayed near 0% until this past March, when the Fed raised it by 0.25%. It was the first interest rate hike since December 2018. Two months later, in May, the Fed once again raised the fed funds rate, this time by 0.50%. Then, this past week, the Fed raised it by 0.75%, the largest single rate hike since 1994.

The Fed’s goal is to slow down consumer spending. By raising interest rates, the Fed is disincentivizing buying goods and services on credit. In theory, reducing consumer spending should gradually reduce the pace of inflation.

The Fed has indicated even more rate hikes are on the way. Wall Street currently projects an 84% probability of a 0.50% rate hike next month in July. This should be followed by three 0.25% rate hikes by year-end and two more in 2023.

According to a recent study by Moody’s Analytics, inflation is costing the average American family an extra $460 per month, or, $5,520 per year, in higher costs. But this puts the Fed in a very difficult dilemma. To help get inflation under control, it must aggressively raise interest rates to put the brakes on consumer spending. Unfortunately, this carries tremendous risk to both consumers and the U.S. economy.

Historically, when the Fed signals it will start raising interest rates, Wall Street wants these rate hikes to be spread out over an extended period of time to allow consumers, businesses and the economy to better absorb the impact. But because inflation has risen so high, so fast over the past 15 months, the Fed is now forced to frontload many of these rate hikes now and in the upcoming months. And that sudden shock to the economy from all those interest rate hikes in such a short, compressed window of time increases the risk of sending the economy into recession.

Obviously, the Fed doesn’t want to force the economy into recession. But raising interest rates is a very delicate balancing act — trying to tame inflation without crushing economic growth. Over the next 6-9 months, we’ll find out just how successful this balancing act was.

Mark Grywacheski is an expert in financial markets and economic analysis and is an investment adviser with Quad-Cities Investment Group, Davenport.

Disclaimer: Opinions expressed herein are subject to change without notice. Any prices or quotations contained herein are indicative only and do not constitute an offer to buy or sell any securities at any given price. Information has been obtained from sources considered reliable, but we do not guarantee that the material presented is accurate or that it provides a complete description of the securities, markets or developments mentioned. Quad-Cities Investment Group LLC is a registered investment adviser with the U.S. Securities Exchange Commission.

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