Taming Inflation With More Aggressive Interest Rate Hikes and Quantitative Tightening
In the most recent Federal Open Market Committee meeting, Chair Jerome Powell indicated he views the U.S. economy to be in a strong position, with consistent job growth and wage increases; however, he sees inflationary pressures to be an ongoing concern for American families – the rise in prices, which are evident in almost all goods and services, are warranting the Fed to take aggressive action in moving towards tightening the monetary policy and preventing an “overheating” situation of the economy. During the meeting, the Fed adopted a quarter percent increase in Fed fund rates – the first rate hike since 2018.
In this article, we’ll take a closer look at the American economic forecast and how Fed’s interest rate hikes will likely impact fixed income markets.
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Measure of Intended Success With Interest Rate Hikes
The anticipated rise in interest rates has been widely talked about for some time; however, for the Fed, it’s certainly a balancing act – and one in which they are taking every step with extreme caution, which also means an increase in interest rates. In the past few months, inflation hit an almost 40-year high at around 8%, and American consumers have been seeing the impacts at all levels of consumer spending. The Federal Reserve has a healthy target for inflation to be around 2%, which they would like to accomplish with the sustained interest rate hikes within the next few years and ensure that tighter monetary policy doesn’t throw the economy into a recession.
With the possible six Fed fund rate hikes that the Fed hinted towards for the year 2022, we can almost certainly forecast a sustained increase in mortgage interest rates, auto loans, credit cards, student loans, etc. A tighter monetary policy will likely lead to decreased demand for large ticket items like home purchases, auto loans, home improvements, etc., as high interest rates will impact consumer affordability of these items, in turn, slowing economic growth.
The aggressive take on interest rate hikes by the Fed has been something that many economists have been predicting to happen in the near future, both due to current inflation levels and other economic indicators: “With the unemployment rate below 4 percent, inflation nearing 8 percent, and the war in Ukraine likely to put even more upward pressure on prices, this is what the Fed needs to do to bring inflation under control,” said Mike Fratantoni, chief economist at the Mortgage Bankers Association.
Beyond the aforementioned pressures on the domestic economy, the Ukraine/Russia conflict and the continued disruption in the supply chain are also going to be ongoing concerns for the Federal Reserve, as the cost increases related to gas prices are primarily driven by the sudden price increase in oil at the international level, and many countries – which have historically relied on Russia’s oil supply – are trying to figure out alternative fuel sources for their countries. This, along with the revival of manufacturing in eastern Asia, that led to the supply chain disruptions, will be an issue that the U.S. has less control over, and it will continue to be an ongoing dilemma.
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Impact on Financial Markets
A comprehensive list of impacts due to rising interest rates can be long; however, for this read, we will keep the likely impacts limited to two ways:
- First is the increased cost in borrowing. This applies to everyone from individuals borrowing funds for personal use to municipal governments issuing debt for capital projects to corporations raising funds through debt. As mentioned earlier, the intended effect of rate hikes is to tame the economic expansion and prevent it from overheating. As rates rise, we may see less municipal issuances or refunding compared to prior years, and a possible slowdown in the housing sector due to the rising cost of borrowings.
- Secondly, fixed income portfolios will likely be negatively impacted in the rising rate environment. This is due to the inverse relationship between fixed income securities and interest rates – when one goes up the other goes down, and vice versa. In this case, fixed income securities with longer maturities, issued during the low interest rate environment, may see significant unrealized market losses for their holders. It’s also important to note that with longer duration securities, investors are unable to reinvest the funds until the security matures and/or they make a premature sale with possible losses.
In terms of the Eastern European conflict, Jason Pride, an investment officer at Glenmede, stated that “The war in Eastern Europe is unlikely to halt the Fed’s tightening plans, but it may prompt caution on the speed of rate hikes as the economic effects of the conflict become better understood.”
The Bottom Line
In current times, we are faced with enormous amounts of uncertainties about the financial markets: the resolution of the Eastern European conflict, a COVID-19 recovery, the resolution of supply chain issues, historically high inflation, sky-high gas prices, the tightening of the monetary policy and how these events will impact the various sectors of our economy. As the Fed indicated, the continuous rise in interest rates seems inevitable, which means that consumers will see a slowdown of our economy, but fixed income investors may see investment opportunities with higher coupons.
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