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.
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.