What The Fed’s Interest Rate Hikes Mean for You and Your Money
If we look at our current predicament with inflation, the problems really began long before last year. Years of “easy” monetary policy by The Federal Reserve coupled with large amounts of cash being injected into the system (thanks in large part to the coronavirus) has given way to runaway inflation. Should the Fed have addressed it sooner? Probably. Is it aggressively (too aggressively?) addressing it now? Yes. The question is what all this means for you, the consumer and investor.
As The Consumer
If one interest rate increase constitutes 25 basis points (or 1/4th of 1%), The Fed has had a whopping 12 interest rate increases in 2022 alone.
What this means for you, as the consumer, is that borrowing money just got a whole lot more expensive. As of this writing, a 30-year fixed mortgage is 7.20%, whereas a year ago this same mortgage hovered under 3%. That is a staggering difference in a 365-day period.
Of course, this is all being done to tame inflation. If money is more expensive to borrow, demand goes down while supply remains constant or goes up. The Fed wants this to happen because this is an integral part of bringing down home prices. There is evidence that this is working, as it appears home prices peaked sometime this past spring.
Similarly to mortgage rates sky-rocketing, the rates for borrowing money via lines of credit have also gone up exponentially. Consumers who rely on lines of credit for purchases will probably rethink this strategy as it just became a whole lot more costly to finance consumer goods.
As The Investor
This piece of the puzzle is a bit more complicated and up for interpretation by some of the smartest analysts in the world. As a normal investor, you’ve seen your portfolio go down this year anywhere from 15 – 35%, depending on how you’re allocated. What we’ve seen so far this year is both stocks and bonds getting clobbered. There have truly been few places in the market to hide. The reason behind that is, again, linked back to interest rates.
Typically, if the Fed is concerned with bolstering the economy, it will cut interest rates, which makes borrowing money easier for both companies and consumers, which in turn will boost the economy. This is a different animal they’re dealing with in 2022. Since inflation has become so “run-away,” they have to increase interest rates to try and stifle the inflation. The direct results of this are bond prices falling in a dramatic fashion this year, given that interest rates and bond prices have an inverse relationship. Let’s say you have a bond paying you 2% interest but because of the interest rate increases, there are new bonds now paying 5%. What many investors have done is ditch their old 2% bonds (which they now have to sell at a discount) for the new shinier bonds that are paying a higher interest rate.
So what about stocks? Interest rates are a discounting mechanism for companies. When interest rates move higher, the value of future earnings looks less attractive. Thus, investors are less likely to buy up stocks so those values have come down exponentially. The missing piece to this large bout of indigestion the market is having is another downside risk investors need to prepare for: earnings have yet to come down on the majority of companies. The fact this risk still exists is worrisome without question. In a year where we’ve seen double-digit losses thus far, the thought of additional, possible losses seems downright exhausting. But that risk still very much exists as The Fed continues to try and wrangle inflation in.
The Silver Lining
Whether it’s the runaway inflation of the 1970s and early 1980s, the tech bubble of the early 2000s or the Financial Crisis in 2008 and 2009, most investors managed to get through these traumas without completely calling it quits on the market. Of course, this didn’t happen without some serious heartburn, maybe some sleepless nights and definitely a lot of conversations with your advisor. We will get through this period of time as well, and if you are an owner of good, solid companies, your portfolio will recover.
We are currently setting ourselves up for another bull market run with current valuations of excellent companies at much lower prices (which may still go lower). What we always remind our clients at Baird Retirement Management is this: Patience and the power of compounding will pay you back in (literal) dividends. We will have another bull market - and you’ll be very glad you hung in there.
Past performance is not indicative of future results and diversification does not ensure a profit or protect against loss. All investments carry some level of risk, including loss of principal. An investment cannot be made directly in an index.