The Federal Reserve has decided to raise the federal funds rate by 0.25% to a range between 5.00% and 5.25%, despite ongoing financial market volatility and issues in the banking sector. Director of Global Macro Jurrien Timmer says the latest rate hike confirms that fighting inflation remains the Fed's top priority.
Inflation threatens the financial wellbeing of investors and consumers alike, so the latest rate hike is part of the Fed's ongoing efforts to slow it, hopefully down to around 2%. Fed leaders hope that continuing to raise borrowing costs will further slow inflation.
While inflation has shown some signs of slowing, stock markets and banks have also been feeling the effects since the Fed began raising rates last spring. Higher rates may bring other challenges, including the possibility that the economy could inadvertently tip into recession.
Why the Fed is still raising rates
The Fed’s mission is to ensure stable prices of goods and services and help maximize employment. It does so primarily by moving the federal funds rate up and down to control the supply and cost of money circulating in the economy.
The ongoing rate increases are part of the Fed's larger goal of “normalizing” interest rates closer to where they have historically been during the various phases of the business cycle, rather than leaving them at the unusually low levels they had been at since the 2008 global financial crisis.
Those near-zero rates helped boost stock prices, but they also penalized the large and growing number of people who rely on bonds, CDs, and other fixed income securities for a portion of their incomes.
In addition to helping slow inflation, Fed leaders seek to eventually wean the economy and markets from years of super-low rates and reestablish the historic pattern in which rates go up to fight inflation when the economy is growing and down to encourage borrowing and spending when the economy is in recession.
Fidelity portfolio manager Lisa Emsbo-Mattingly says the Fed and other policymakers typically respond decisively when faced with a crisis such as the COVID shutdowns or the war in Ukraine. Those responses can include quickly raising or lowering interest rates.
After a rapid response, says Emsbo-Mattingly, the Fed and policymakers tend to hesitate to change policies abruptly again. “I think the policy decisions of the last dozen years were all done in the spirit of doing the right thing, but I think that the Fed is in a very tough situation with a financial system that’s become very, very dependent on what they do,” she says.
Source: Fidelity Investments (AART) as of 12/31/2021. Stock performance represented by S&P 500.
What higher rates mean for bonds
The clearest beneficiaries of higher rates are those who invest in bonds primarily for income or in other fixed income securities such as CDs. Typically, when interest rates rise, newly issued bonds may pay higher yields, while prices of bonds that are currently in the market decline. Last year, prices of those existing bonds fell as investors anticipated the impact of higher rates and sold many of their bonds.
Since then, higher rates and stock market volatility have increased the appeal of bonds as both sources of income and preservers of capital in portfolios. The steep rise in stock prices from 2020 to 2022 reflected the belief of many investors that low interest rates offered them few alternatives to stocks. With rates and yields on bonds rising, though, some investors have turned toward bonds and away from stocks. Although higher rates can hurt prices of bonds already in the market, bond investors can manage that risk by focusing on bonds that have lower duration, or sensitivity to changes in interest rates.
What higher rates might mean for stocks
Since rates began to rise last year, US stocks have struggled. As rates have continued to rise, earnings of many companies have been affected in the short term as their costs have risen along with inflation and interest rates. In the longer term, stocks of companies that can pass their higher costs along to consumers may be able to grow their earnings even if rates remain high. Indeed, historically, stocks have delivered lower returns immediately after the start of a period of rate increases, but returns have increased over the longer term.
Overall though, the path back to tighter monetary policy could remain rocky for stocks: "Everyone was dependent on those super-low rates, and since the Fed has been raising rates, it has been rough," says Emsbo-Mattingly.
While some investors may hope the Fed will lower rates soon because they believe it will help stocks, Emsbo-Mattingly says they should be careful what they wish for. “If the Fed does pivot and start cutting rates, it's going to be for the really good reason of trying to avoid or end a recession,” she says.
Potential or actual stock volatility shouldn’t excessively worry long-term investors, though, as higher rates are apt to eventually slow growth and inflation and markets should adjust to the new interest rates.
Keeping perspective
History shows that rate increases are often accompanied by stock market volatility and even sizable pullbacks, as in 2022 when higher rates were followed by a brief 20% correction in the S&P 500®. But rising interest rates are no reason for long-term investors to abandon well-diversified financial plans. Instead, they should focus on their longer-term goals and try to maintain a healthy perspective on short-term news events.