October 27, 2022
The U.S’s central bank, The Federal Reserve, topped off its two day Federal Open Market Committee (FOMC) meeting last week by raising interest rates by a quarter point – something which was already widely expected and priced in on markets.
The hike means that benchmark interest rates, which have sat at rock bottom since they were dropped in the early days of the COVID-19 pandemic, will now sit at a range between 0.25% and 0.50%. The hike on Wednesday was the first since December 2018.
However, the world won’t have to wait long for another hike: The Fed said six more hikes would take place this year, which will happen at each of the Fed’s remaining 2022 FOMC meetings. In spite of that added clarity, what kind of hikes we can expect is up to the imagination – however, assuming a 0.25% raise at each meeting, U.S. rates would end up at just below 2% at the end of the year.
Investors responded kindly to the hike. Stocks had their best week in 16 months. However, the retail crowd – especially ones which have never seen a full market cycle – might be perplexed by what interest rates have to do with stocks, crypto, and their other investments. After all, don’t interest rates just affect bonds?
Some members of the Front community, especially new investors, have asked: why do interest rates matter?
We expanded on this topic nearly a year ago in a long piece where we explained the finer points of monetary policy. However, for those of you who don’t have the time to spend on reading a “too long; didn’t read” (tl;dr) of how interest rates and monetary policy work – we’ve tl;dr’d the tl;dr for you.
As America’s central bank, the Federal Reserve has unprecedented control over monetary activity and markets. That’s because the Fed has an important job – to conduct national monetary policy, supervise and regulate banks, maintain financial stability, and provide banking services.
One way that the Fed can affect change in these important factors is by changing interest rates. For today, think of interest rates like a dial.
In conditions like we’ve seen since the COVID-19 pandemic started, the Fed turns the dial down – making interest rates lower, or in this case, reducing them to 0%. Doing this helps boost the economy by encouraging investment, borrowing, and other things. The Fed mostly achieves these rates by helping target inflation, ensure price stability, and create a stable economic environment able to foster the goal of maximum employment.
Because of low borrowing costs, stimulus, government spending, supply chain problems specific to the COVID-19 pandemic, and a shortage of employees who needed to work, the economy grew – but so did inflation. In fact, inflation is up about 8% YoY.
Those inflation figures are way too hot for comfort, especially as economic growth – one of the Fed’s desired outcomes – slows down. So, in order to arrest high inflation, the Fed has begun turning up the interest rate dial.
However, they can’t turn it up all at once; they need to turn it up slowly and incrementally. As rates rise and the Fed’s asset purchases stop (“the taper”), the economy will slow down… and that should (theoretically) banish high inflation figures from the economy.
Practically speaking, this means a few different things for investors. Among them are good things – like higher interest rates at your bank (which is great if you’re an avid saver). The higher rates also usually result in lower inflation figures.
There are some bad things, though: for one, asset prices tend to drop when interest rates rise. That means that stocks, the price of cars and houses, and other goods might fall… which is bad for investors! Interest rates rising also mean you’ll spend more to borrow money to make important purchases. And naturally, falling asset prices and higher costs to borrow bring about risks for a recession… which is an event during which economic growth actually declines for a period of time.
However, though conventional wisdom would say stocks should drop during interest rate hikes, they actually did the opposite this week. Perhaps investors have seen the rate hike campaign as a positive thing for an economy deeply embroiled in aggressive inflation – and perhaps investors aren’t running away from stocks and assets which have delivered great returns during trying times.
Sure, living in a world with perpetually low interest rates sounds great. However, it’s not! This rate hike campaign should restore a sense of normalcy to the markets. Nobody said it would be great for your stocks or crypto – but if you stay diversified and keep a long-term vision, that likely will not be a problem!