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One foot on the brake, and one on the gas

Key takeaways

  • After taking a break in June, then raising rates in July, the Federal Reserve has again paused its policy of raising interest rates to fight inflation.
  • An ongoing review of how high rates are affecting inflation, economic growth, and the job market is influencing the Fed’s decisions.
  • The Fed is likely to keep rates high for a while and could even raise them again in November or December.

The Federal Reserve is trying to slow inflation down but also avoid running the economy and financial system off the road in the process. That's why after more than a year of making rapid and steep increases in the federal funds rate, the Fed has now hit the brakes on further rate hikes twice in the last 4 months. The latest pause comes at the Fed's September meeting and follows an increase in July and a pause in June and leaves this important interest rate in a range between 5.25% and 5.50%.

The shift in monetary policy from full-throttle acceleration to cautious crawling doesn't mean the Fed has become less concerned about inflation. Fed Chair Jerome Powell has said repeatedly that inflation threatens the financial wellbeing of investors and consumers alike, and the Fed remains committed to slowing it, eventually down to around 2%. "The worst outcome for everyone would be to not get inflation under control now," he says.

Fidelity fixed income macro strategist Kana Norimoto explains that the Fed is relying on economic data as it makes decisions about rates. “The Fed is moving with caution now that policy rates have reached restrictive levels," she says. "They're very much in a data-dependent mode and they’ve become concerned that stronger economic growth will scupper their efforts to bring inflation down in a sustained manner. Some of the Fed's leaders are also increasingly concerned about the health of the job market and Powell is trying to balance their concerns with the goal of bringing inflation down."

Following its September meeting, the Fed gave an idea of what it's seeing in that data as it released its quarterly Summary of Economic Projections (SEP). This quarter's SEP shows the Fed now expects stronger economic growth and lower inflation and unemployment for the rest of the year than it had predicted back in June.

What the Fed may do next

The Fed's leaders have already given signs that this revised forecast for growth, inflation, and employment may mean the upward surge in interest rates is nearing an end.

Or maybe not. "I think Powell has made it pretty clear that he thinks interest rates are high now and are getting closer to a level where things in the economy could start to break, so they want to be very careful moving forward," says Norimoto. "The federal funds rate could still top out at 5.6%, which is what's been expected since June, but they'll continue to rely on data to see how inflation develops and how labor markets are doing. They also now have rising oil prices to be concerned about. I don't think they want to say what they might do in November or December. They want to keep their options open but not surprise anybody. I think that's the approach."

But while the Fed may be leaving its options open in the near term, Norimoto says that one thing does appear clear: Rates aren't likely to come down anytime soon. "I think that the position of the Fed is that they really want to maintain rates at a high level for a considerable period of time and there's no reason to expect a rate cut anytime before 2024," she says.

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What continued high rates may mean for bonds

The clearest beneficiaries of high rates have been those who invest in bonds primarily for income or in other fixed income securities such as CDs. Higher rates have increased the appeal of fixed income investments as both sources of income and preservers of capital in portfolios. If rates remain higher for longer, investors in individual bonds, money market mutual funds, and CDs may continue to find attractive opportunities for income.

Although changes in interest rates can affect 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.

Source: Fidelity Investments (AART) as of 12/31/2021. Stock performance represented by S&P 500.

What continued high rates might mean for stocks

After rates began to rise last year, US stocks struggled at first. As rates have risen, though, stocks have recovered, much as they have during previous rate-hiking cycles, as shown in the chart above. Historically, stocks have delivered lower returns immediately after the start of rate increases, but returns have increased over time. While an eventual rate cut might sound appealing to stock investors, it's worth considering that if the Fed were to start cutting, it would likely be doing so because signs of recession had increased significantly, something that wouldn't likely be good news for stocks.

Potential or actual stock market volatility shouldn't excessively worry long-term investors, though, and whether rates move higher, lower, or nowhere, markets should adjust as they have historically.

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This information is intended to be educational and is not tailored to the investment needs of any specific investor.

Fidelity does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation.

Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal.

The S&P 500 Index is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent US equity performance. Indexes are unmanaged. It is not possible to invest directly in an index.

In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible. Any fixed income security sold or redeemed prior to maturity may be subject to loss.

Like all fixed income securities, CD valuations and secondary market prices are susceptible to fluctuations in interest rates. If interest rates rise, the market price of outstanding CDs will generally decline, creating a potential loss should you decide to sell them in the secondary market. Since changes in interest rates will have the most impact on CDs with longer maturities, shorter-term CDs are generally less impacted by interest rate movements.

Views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. Unless otherwise noted, the opinions provided are those of the speaker or author and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.

Past performance is no guarantee of future results.

Diversification and asset allocation do not ensure a profit or guarantee against loss.

Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money.

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