Interest in Interest Rates

Interest in Interest Rates

The story of the year has been inflation and interest rates, to say the least.  It has essentially been the tail that has wagged the dog for all of 2022.  The Federal Reserve went into the year suggesting they would raise rates about 3 times this year, all for about .25% for a total of a .75% rate increase.  Due to runaway inflation, the Fed has had to drastically increase the rate increases much more than anyone expected.  Heck, each of the last 4 Fed meetings this year has led to a .75% interest rate increase.

So, where does that leave us today, and in the future?  As you can see, we went into the year with a Fed Funds Rate between .25% and .50%.  With the most recent interest rate increase, we are now hovering in the range of 3.75% to 4%.  The question at hand is where do the pundits expect things to go?

Where Interest Rates May Go

The consensus amongst economists is we will likely have about 2-3 more rate increases in the next few meetings.  For context, the Fed gets together one more time this year in Mid-December, then not again until the end of January.  These economists are suggesting the Federal Reserve terminal rate (or the rate they stop raising at) is 4.5-5.0%.  Also, due to Fed Chairman Powell’s latest comments, we do see the rates likely slowing over the next meeting or two. 

That all said, the Fed has suggested its main goal is to combat inflation, at all costs, and we all know the biggest weapon in its arsenal is interest rate hikes.  The question I find really interesting is what happens after we hit the “terminal rate”?  The consensus, again among economists, is it will hover there for a while as inflation ticks down.  Then the Fed will likely slowly lower rates until we landed somewhere in the 3%-4% long-term range.

It is important to remember where we were at the beginning of the year was an extremely low rate of .25%.  This was due to the accommodative policy set by the Fed to help jolt the economy during the pandemic.  We saw similar policies during the 08 crisis when the Fed deployed Quantitative Easing 1-3.  These are all resources the Federal Reserve turns to when it needs to jump-start a stalled economy. The fact that we haven’t seen inflation pick up in decades allowed for the Fed to maintain this very accommodative stance.

Today we are seeing the opposite effect play out.  The Fed is trying to slow the economy simply to combat inflation.  This is why most economists assume once we see inflation start to come down, we will likely see a long-term rate of 3-4%. 

The best way I like to think about it is the Fed is our parent.  When we need lifting up, they will do what they must in order to make life better.  Conversely, when we are acting up and need to be punished, they will restrict things and make life harder for us.  At the end of the day, much like a parent, they really want to see us flourish on our own without much involvement from them. 

The Hope

The hope is that we start to see inflation systematically come down over the next couple of months.  We know that raising rates is a lagging effect, so we do have to sit on our hands for a bunch of months to see things truly play out.  From there if we see the Fed policy working we can all breathe a sigh of relief that we can start to work our way out of this thing on a road to recovery.

The Fear

Naturally, the fear is the opposite.  The concern would be that inflation remains extremely stubborn and thus the Fed must go through drastic measures to slow inflation and the economy.  This would lead to a more drawn-out recession and a longer recovery.  No one is rooting for this naturally, and we are starting to see signs of inflation slowing.

Last note

I find this an interesting case study, as it has been 40 years since we’ve had to tackle runaway inflation.  At Diversified, we are in the camp that things are starting to slow and inflation come down.  We also see the terminal rate in that 4.5-5.0% range and albeit a recession, not a prolonged one.  Likely, there will be a rebound next year at some point as things bottom out and we hit the road to recovery.

At the end of the day, it does not change the investor playbook.  Stay invested, stay diversified, and remain calm as this too shall pass.

As always stay wealthy, healthy, and happy.

If you prefer to watch our blogs, here is the video version: