The Who, What, and Why of Rising Interest Rates
The Federal Reserve System, or “Fed”, is the central bank of the United States, and it has two prime pursuits. Those pursuits are full employment and steady prices. The tool that it uses to influence these things is the ability to raise and lower interest rates. Lowering interest rates promotes borrowing and spending, but, left unchecked, leads to inflation. Raising interest rates increases the cost of borrowing and increases the incentive to save (think higher savings account and CD rates). Higher rates are designed to slow spending and borrowing, but also lead to slower economic growth and left unchecked, a recession.
Inflation is essentially too many dollars chasing too few goods and that leads to increases in prices. The COVID pandemic and shutdown created a perfect inflationary storm. Shutdowns and supply-chain issues have limited supply for many necessary goods (think new cars). The government stimulus supplied consumers with the cash to buy these goods, but a lack of supply increased prices. Our too many dollars chased too few goods and now we have record inflation.
After the Great Recession in 2008-2009, The Fed took aggressive action, lowering interest rates and supplying the economy with liquidity (cash). This was a necessary step and proved to be the saving grace for a struggling economy. Starting in 2014 and continuing into 2018, The Fed began slowly increasing interest rates to create economic balance. Remember, 0% interest rates and 0% inflation are unsustainable and are an anomaly in the history of the global economy. Historical interest rates in a healthy economy are slightly higher than where we are today, and inflation should be in the 2-3% range. The Fed knew that and had a plan in place and then... COVID. The Fed aggressively lowered interest rates and flooded the market with liquidity to save an economy that was shut down due to COVID. Couple that with $4+ trillion (that's trillion, with a "T") dollars in government stimulus and we were left with a whole lot of consumers with cash and nothing to do but spend it. And that brings us to today.
- As expected, The Fed raised interest rates 75 bps (3/4 of 1%) and indicated that they will continue to take aggressive actions (raising interest rates even further) to battle inflation. What this will ultimately do is decrease the number of dollars in the economy (slowing growth) and hopefully lower inflation. Because the Fed can only control the demand side (how much money is out there), it could use some help on the supply side. Fixing the supply-chain issues and ending the war in Ukraine would speed this process along greatly. Once inflation is under control, the Fed will begin lowering interest rates again (but not back to 0%) to stimulate the economy and create a new economic cycle.
- If GDP (the measure of economic growth) slows too much, and turns negative for 2 quarters, then we are in a recession. We've already seen a decrease in GDP for the first quarter of 2022 and will find out in July if we've seen the same negative growth in the second quarter. Whether we are in a recession, by definition, right now or not is a moot point. We know that The Fed is signaling slower growth going forward and what we're looking for right now is duration (how long it lasts).
- Recessions signal the end of an economic cycle and as painful as they potentially are, they are necessary. This economic cycle began sometime around 2009 and has continued basically uninterrupted since then (ignoring the COVID recession that was event-driven and doesn't really count). We all remember The Great Recession (lasted 18 months), but we also had recessions in 1990 (8 months) and 2001 (8 months, included 9/11). Each of these times created a tremendous buying opportunity and investors were handsomely rewarded for the purchases they made. Remember, the market will recover long before the economy does. That's why the best time to buy always seems like the worst.
- Turn off the news. Kevin's Law states that there is an inverse relationship between news consumed and happiness.
- If you feel uncomfortable with your personal financial situation (job security for example) hoard cash. If the worst happens, cash can turn emergencies into inconveniences. If it doesn’t, you have a big pile of cash.
- If you feel secure in your personal financial situation, look for opportunities to increase retirement plan, 529, HSA, and investment account contributions. I truly believe that you will be handsomely rewarded for the buys that you make today, but I have no idea when.
- If it makes sense, consider a Roth conversion to create a bigger pile of tax-free dollars.
- Focus on how these things effect you and what you can control. Rising mortgage rates and potentially declining real estate prices don't matter if you're planning to die in your current home (like I am).
- Remember - this too shall pass (man I've said that a lot over the last few years). I believe that there are only two possible scenarios. Scenario 1 is that I'm right and the economy and market will recover at some indeterminate time in the future. Scenario 2 is that this is the Zombie Apocalypse, and you should have traded your 401k for guns and canned goods. This too shall pass, and the best is yet to come.
- Set some time for us to talk. We have long considered ourselves 50% Financial Advisor and 50% Therapist. If you'd like for us to explain it further, or tell you what’s right with the world, we are happy to do so.