It sure feels like they are. Fed chair Jerome Powell talked about the “economic pain” that would result from rate increases after the Fed's September meeting when they increased rates another 0.75%. He made it clear that the Fed was willing to push the economy into a recession to get inflation under control.
What a change from a year ago when the Fed still had interest rates pegged at zero, was telling us inflation was “transitory” and they expected it to fade away on its own!
So what’s driving this about face from the Fed?
Congress gave the Feb two mandates – full employment and stable prices. The full employment part is fine; unemployment is at 3.7% and there are almost 10 million job openings (1). Stables prices are the problem. Inflation is way too high – the consumer price index hit 9.1% in June (2). Gas prices have come down a lot from earlier this year but food prices, rents and most other prices are still increasing too fast.
The Fed uses the core PCE index (personal consumption expenditure) to track inflation outside of food and energy. The PCE index increased 4.9% year over year as of September 30th, which is much higher than the 2% rate the Fed wants to see (3).
If you’re a central banker, how do you control inflation? You make money cost more by raising interest rates. Mortgage rates go up, credit card rates go up, companies’ borrowing costs go up. Increasing borrowing costs slows demand for houses, apartments, cars, appliances, vacations, groceries and everything else. The Fed hopes prices of all these things will stop going up.
The problem is making money cost more won’t fix shortages that still exist after the pandemic. It won’t make supply chain problems better. It won’t make more computer chips available; it won’t increase food or dairy production; it won’t make natural gas cheaper in Europe or cause Russia to end the Ukraine war and bring oil prices down.
Think about making a piece of furniture if you only have a hammer in your toolbox. You might eventually be able to make a table out of a slab of wood if all you have is a hammer, brute force and a lot of time, but it won’t be pretty and it isn’t going to be kind of table I want to own.
This is what markets are grappling with – are the Fed’s interest brute force rate increases going to damage the economy and markets more than the Fed thinks?
The Fed’s rate increases are having an impact. The financial markets are sending that message loud and clear.
Stocks and bonds are having one of the worst years in the last fifty. Bonds are going down in price because new higher interest rates make bonds that governments and companies issued when rates were near zero look unattractive.
Stocks are going down because higher interest rates make future profits from stocks look risky compared to bonds. Investors worry the Fed will cause a recession that will hurt corporate profits. Declining profits aren’t good for stocks.
Now for the good news:
- Bear markets end. All the declining markets in US history have ended.
- Stocks are much more reasonably priced than they were 9 months ago and there are real values on good companies because prices have dropped.
- The yields on bonds are attractive – 4% on short term US treasuries and over 2.6% on money market funds (4).
- Low inflation is good in the long run. Stable spending power is good for both consumers and businesses.
The Fed wants to slow the economy, but it really doesn’t want it or markets to crash. If the economy slows too much and unemployment goes too high the Fed will have to reverse course and cut interest rates. It is a tough balancing act.
It is important to keep perspective as an investor. The last time the Fed raised rates this dramatically to combat inflation was 1994, when the Fed raised the short term rate from 3.05% to 6.05% (5). That also led to a tough year for both the stock and bond markets, but the following five years from 1995 to 1999 were five of the best years for stock returns in the last fifty years (6). Getting inflation under control may cause short term pain, but also lead to long term gains.
Footnote: 1994 wasn't all bad - the Browns went 11-5 and made the playoffs with Vinny Testaverde as their quarterback, Bill Belichick as coach and Nick Saban as defensive coordinator. (7)
(1) https://www.bls.gov/cps/ and https://www.bls.gov/jlt/
(4) https://www.cnbc.com/bonds/ and https://www.wsj.com/articles/cash-best-interest-rates-on-cash-investments-11664550519?page=1