In the past few weeks, we have continued to face elevated volatility in the financial markets due to higher inflation and rising interest rates.
Is the Fed actively trying to crash the stock market, housing market, and push the economy into a recession? In the post we’ll dig deeper into the role of the Fed and their impact on the overall economy.
Who Is The Fed?
The Federal Reserve (Fed) is the central bank system of the United States. It plays an enormous role in keeping the economy stable. Their primary goals are maximum employment and price stability.
The Fed has deemed that targeting 2% inflation is the best way to achieve price stability. A modest rate is generally considered good for the economy because it can coincide with wage growth and maintain consumer demand.
How Does The Fed Impact Inflation?
Their main tool for controlling inflation is its ability to raise or lower the federal funds rates. Low rates help boost the economy making it cheaper for businesses and households to take out a loan.
When the Fed raises its rates, all kinds of lending become more expensive. Mortgage rates and auto loans go up. And that helps reduce demand, thus lowering prices.
Why Raise Rates?
For much of 2021, the Fed used the word “transitory” to imply that higher prices will be short-lived. It was supposed to be transitory, and it wasn’t. In August, inflation was 8.3 higher than the year prior. Now the Fed has to move quick with their tightening (i.e. raising rates):
Central bankers believe that these rate hikes are necessary even with the risks of recession. A downturn that pushes unemployment high would be painful, but inflation is also a major impediment for many families today. Jerome H. Powell, the Fed chair said that “we will keep at it until we are confident the job is done.”
What Does it Mean for Housing?
For much of the pandemic, the Fed kept rates near zero, which meant historically low mortgage rates. That led to the housing market overheating. Home prices increased 31% on average the past two years. This rate of change isn’t sustainable.
By making money more expensive to borrow, the Fed has started to reduce housing demand. For example, two years ago the 30-year mortgage rate was 2.87% and today it’s 7.6%. In result, the payment on a $500,000 home went from $1,658 to $2,824! Housing prices will likely come down because the decrease in purchasing power from buyers.
What Does it Mean for Car Prices?
Besides your home, your car is your second largest expense. Used car prices soared in 2021 and recently they have started to trend down again. Late Q4/ early Q1 are always slow for used car dealers. Combine that with declining demand and you might be able to find some bargains. Be patient if you are in the market for a used car.
What Does it Mean for the Stock Market?
While both home and car prices will take some time to adjust, the stock market will be forward looking. The valuations we see today reflect expected future earnings.
So far S&P 500 is down 24% or so from all-time highs. This is below average for bear markets, and it is possible prices could fall further. But if you are a net saver in stocks, this is a good thing because it allows you to buy stocks at depressed prices.
What Does it Mean for Bond Prices?
Bonds are beginning to look much more attractive at the current interest rate levels. Short and intermediate-term U.S. government bonds yields are at their highest level since the Great Financial Crisis.
There is finally some decent yield to be earned on government bonds, corporate bonds, TIPS, I-bonds and even savings accounts for the first time in years.
Bottom Line
There will be some challenges ahead for the economy as the Fed continues to raise rates. But getting inflation under control is critical to getting the economy on a sustainable path.
As the Fed continues to battle inflation, you will have the ability to acquire assets at lower prices. If you are in the accumulation phase, be patient and view these declines as an opportunity.
Sources/Disclaimers:
Pace of rate hikes chart from @KathyJones
Inflation is up 8.3% year over year from the U.S. Bureau of Labor Statistics
Used Car Prices from Manheim Used Vehicle Value Index
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
