What to Expect with Fed Rate Hikes

At its March 2nd Federal Open Market Committee (FOMC), the Federal Reserve board voted to raise short-term rates another 25 basis points—the second such increase this year. It was the ninth rate hike since March 22, 2022, in an all-out effort to tame rising inflation, which had surged to its highest levels in 40 years.

The number of rate hikes is not unprecedented—the Fed increased rates 17 times between 2004 and 2006 to cool a bubbling housing market. What is unprecedented is the velocity of the rate hikes, taking the short-term rate from near zero to nearly 5.0% in a relatively short period of time. That period included four increases of 75 basis points and two 50-point hikes. Such steep increases have been unheard of in the last three decades.

By some measures, inflation appears to be cooling somewhat though prices of many essential items remain at record high levels. Where the Fed goes from here is not entirely clear. Since its initial burst of rate hikes last year, the Fed has been walking a tightrope in trying to curb rising inflation without tipping the economy into a deep recession.

Recent Events Increasing Fed Challenges

In an ideal world, the Fed would be able to gradually moderate inflation by closely calibrating its rate hikes until demand and supply are balanced while allowing the economy to grow. But the events of the first quarter of 2023 have reaffirmed that this isn’t an ideal world, which complicates the Fed’s job and notches up the tension on the tightrope.

Though the stock market rebounded nicely in the first quarter, it wasn’t without significant economic and geopolitical drama, creating a wall of worry for the market to climb. In just three months, we’ve experienced several remarkable and potentially cataclysmic events, including:

• Rising tensions between the U.S. and China punctuated by the downing of a Chinese spy balloon that was allowed to traverse most of the U.S.
• The U.S. inching closer to a “hot war” with Russia as it escalates its military aid to Ukraine.
• The second largest bank failure in U.S. history with fears of more to come.
• Brazil and Saudi Arabia joining China, Russia, and a dozen other countries in replacing the U.S. dollar as their primary trading currency.
• An unexpected reduction in oil production by OPEC+, driving up oil prices sharply with an increase in gas prices to follow.
• Lingering concerns over an imminent recession.

And that was just one quarter. In most years, any one of these events would weigh heavily on the U.S. economy. The Fed must contend with all of them at once as they consider their next move.

How Did We Get Here?

With interest rates already near zero at the beginning of the pandemic, the Federal Reserve put quantitative easing on steroids as the economy plunged into a recession, ballooning the federal balance sheet to nearly $9 trillion. This was done to increase the money supply and stimulate economic growth during the damaging COVID pandemic. As the growth of production of goods and services slowed, the raging money supply growth eventually overtook it, causing the price of goods and services to be bid up. When too many dollars are facing too few goods, you get inflation.

Then add in supply chain issues and increasing wages occurring at the time, causing employers to have to pay more to get people to come to work. That contributed heavily to inflationary pressures on the market. Despite the record low unemployment numbers at the time, there were still four to five million people not working, not contributing to production, which also contributed to the supply chain issues and rising prices.

Often ignored in the inflation equation is the velocity of money—the rate at which money is exchanged in the economy. Following the financial crisis in 2008 and the COVID pandemic in 2020, consumers were more inclined to save their additional dollars out of caution. During COVID, it was also because many services were no longer available for purchase, such as travel and restaurants.

Then, as COVID restrictions lifted, consumer activity reached pre-pandemic levels, increasing the velocity of money and setting the stage for more prolonged inflation.

As the inflation rate began to tick up in 2021, the Federal Reserve viewed it as transitory, caused by temporary supply and demand imbalances that would self-correct. That didn’t happen and inflation worsened, catching the Fed and everyone else off guard. That’s the reason the Fed took such drastic actions in 2022, increasing fears it could lead to a deeper recession.

Where We Go from Here

 Consumers have been spoiled by low interest rates for a while. However, to put higher rates in perspective, mortgage rates, which are currently hovering around 6%, were as high as 18.5% in the 1980s. A normal business cycle lasts about six years, which usually encompasses an economic slump and an economic recovery.

Coming off a deep, albeit short-lived, recession in 2020, interest rates were kept low for an extended time and must now rise to combat inflation. The good news for consumers is an increase in rates is inevitably followed by a decrease in rates. The bad news is that it typically happens when the economy is slowing down.

The best advice for everyone is to stay focused on their financial goals and save or invest for the long-term because no one can predict the direction of the economy or interest rates.