Last month, the Federal Reserve increased interest rates again, the ninth consecutive increase since the Fed began raising rates in March 2022. While the full effects of the latest rate hike remain to be seen, analysts debate whether the Fed will raise rates again at its next meeting in May.
This is the big question on the minds of many Americans: Will increased interest rates push the economy into a recession? Higher interest rates make borrowing more expensive and indirectly limit consumer spending, pushing down demand for goods and services and leading the economy closer to a recession. Here is what you need to know about the rate hike campaign we’ve seen over the last year and where rates may go in the coming months.
- The Federal Reserve raised interest rates by 400 basis points in 2022.
- Chairman Jerome Powell has indicated the potential for a slowing of the pace of increases, but nothing is set in stone and many analysts expect one more rate hike in 2023.
- Higher interest rates hurt some industries while others benefit from them. Investors need to know this to make smart financial moves.
Fed Rate Hikes for 2022
The Federal Reserve met on March 17, 2022, to discuss raising the federal funds rate. Data from the Consumer Price Index (CPI) at the time indicated the annual inflation rate was at 8.5%. This was a pretty shocking number and the Federal Reserve took swift action to combat increased prices.
The Federal Open Market Committee (FOMC) has eight regularly scheduled meetings throughout the year. At seven of these eight meetings in 2022, the Fed decided to raise interest rates by either 25, 50, or 75 basis points.
Near the end of 2022, Fed Chair Jerome Powell noted that the pace of rate increases would eventually slow. However, he did not set a timeline for when that might be, and we’ve seen two rate hikes since then in February and March 2023, both of 25 basis points.
What Causes Inflation
A mismatch between supply and demand is the most basic explanation of what causes inflation.
For example, when supply lines were interrupted due to the COVID-19 pandemic, some industries grew accustomed to an environment of low demand for their products. Oil companies, for example, didn’t need to transport as much of their product around the globe since fewer people were driving their cars. When restrictions eased and demand for gas increased, these companies had to increase prices because demand was outpacing the available supply.
Another inflationary factor from 2022 was the circulation of stimulus money in the economy. During the pandemic, the government sent out stimulus checks to encourage consumer spending and avoid an even worse recession. These checks gave consumers greater discretionary spending power, and the increased demand for goods and services contributed to rising prices.
So sudden increases in demand or limits to supply can cause inflation. If the cost of a raw material or labor increases, it can also lead companies to raise prices, effectively passing increased costs onto consumers.
What Does Raising Interest Rates Do?
The Federal Reserve controls the fed funds rate, indirectly influencing the rate at which banks lend each other money from their reserves. Banks must meet reserve requirements related to how much money they have on hand, so a higher fed funds rate encourages banks to save money and give out less to borrowers.
Higher fed funds rates translate to higher costs for short-term borrowing and higher yields on savings products. This is because banks want to incentivize people to deposit money with them. Credit card interest rates (because they’re variable interest rates) also move in lockstep with these changes in interest rate, so the cost of holding debt increases. Housing starts tend to decrease when interest rates are high, and people generally save more money and spend less.
Higher interest rates can lead corporations to move away from growth projects and can lead investors to remove their money from the stock market, anticipating decreased revenue. What should be clear is that when the Fed raises interest rates, they hope to take money out of the economy, allowing time for prices to stabilize.
It’s important to note that the Federal Reserve doesn’t set mortgage rates or the rate banks lend each other money overnight. The Fed influences short-term and variable interest rates by setting its fed funds rate higher or lower.
Stock Market Reaction to the Rate Increase
The stock market experiences different reactions to the Fed’s meetings. For example, when the market heard that the Fed planned to slow the pace of interest rate hikes in November last year, the S&P 500 Index increased by 1%. However, when they heard that the Fed intended for real interest rates to be raised, the S&P reversed course and ended down 2% for the day.
The Dow Jones swung over 900 points after the Fed’s November meeting — first up nearly 500 points, only to close down over 400 points from the beginning of the day. The NASDAQ Composite closed at 10,524.80 for a loss of 3.3%. Tech stocks suffered a loss of 3% in stock value, including majors such as Alphabet, Apple, Netflix, Amazon, and Microsoft.
Announcements of rate hikes tend to hurt the stock market, while announcements of easing rates tend to encourage investors to put money into stocks.
Changes in Policy Moving Forward
The Federal Open Market Committee is seeking a balance of maximum employment and driving down the inflation rate to 2% over time. The FOMC is firmly committed to reducing inflation to 2% and won’t deviate from its plans unless an event requires a change. Once inflation reaches the 2% mark, the Fed will consider reducing the federal funds rate.
Investors have been hopeful for a slowdown in the pace of increases, but this has not been the case yet. While there might not be a need for 75 basis point increases at the next few meeting, it’s very possible the Fed will raise rates another 25 basis points next month. Until now, the Fed has been aggressive with rate hikes because rates were effectively at 0% early last year.
Currently, rates are restrictive, meaning they should begin having a greater economic impact. As a result, the Fed needs to be diligent in reviewing economic data to ensure they are not too aggressively discouraging spending.
Furthermore, Fed Chairman Jerome Powell has indicated in the past the Fed wants to get to a place where real interest rates are positive. This means that interest rates have to be higher than the inflation rate.
With interest rates currently at 4.75% to 5.00% and March’s annual inflation rate at 5%, we’ve almost reached that point.
The FOMC still feels and anticipates that ongoing increases in the federal funds rate are an appropriate tactic to reduce inflation. It monitors the effects of tightening monetary policy, economic and financial developments, and the lag when monetary policy affects economic activity and inflation.
The Fed has also reduced its holdings in Treasury securities, agency debt, and agency mortgage-backed securities. These plans were laid out in the Fed’s plans to reduce the Federal Reserve’s balance sheet size in May 2022.
With the past year’s many rate increases, there are specific industries that have felt the impact more than others. The rise has undoubtedly hurt homebuilders as mortgage rates become higher for home buyers, slowing down demand for housing even further.
Banks have arguably benefitted from the rate increase. Since there are fewer mortgage applications, the banks can charge higher rates to those still buying homes. Banks with a credit card arm (and credit card companies in general) have also benefitted as they have raised the interest they charge on balances, leading to more income.
The service and hospitality industry has suffered from rate hikes. Higher interest rates with persistent inflation translate to fewer people willing to spend money on travel-related expenses. More and more of consumers’ income is going towards surviving and not spending on discretionary categories.
Higher rates have a smaller impact on healthcare and consumer staples. People need healthcare and food regardless of whether the economy is strong or weak or whether interest rates are high or low.
As an investor, it’s important to understand how interest rates impact various industries so you can make smart financial decisions. Even though a stock might look attractive after being beaten down, there is no immediate need to invest if it is negatively affected by higher rates. Alternatively, if a stock is unaffected by rates and has fallen in price because of general market decline, it could signal a buying opportunity.
The Bottom Line
The Fed has increased the fed funds target rate by over 400 basis points since March 2022. Investors have been hoping for signs the Fed would pause future rate hikes, but this has not yet happened. The Fed will likely raise rates until inflation drops to an even lower point. At that point, the Fed will change course and work to limit the economic damage from high rates while also trying to keep inflation down at 2%.
The takeaway from the latest Fed meeting is investors will need to keep looking at all the economic data. You can track future Fed meetings to gauge when the Fed believes it has accomplished its plan to control inflation.