Market Insights: Rate Hikes

Dylan Potter, CFP®, Vice President, Wealth Manager

Market Insights
On Thursday the Labor Department stated that January’s Consumer-Price Index—which measures what consumers pay for goods and services—reached its highest level since February 1982, on an annualized basis. The inflation print came in at 7.5%, firmly above the 1.8% annual rate for inflation in 2019 ahead of the pandemic. Our economy is unusually strong and flush with cash from waves of government stimulus, so now the job of bringing inflation under control falls to the Federal Reserve.

Supply and Demand

To simplify a very complex issue, there are effectively two sides to the inflation coin…supply and demand. As we’ve all personally experienced, COVID-19 forced businesses to shutter. To survive, businesses laid off the work force, sold inventory at extreme discounts, sold PP&E (property, plant, and equipment) so they could raise cash to weather the storm. We’ve learned firsthand that it’s much easier to close the factory and turn off the lights than it is to reequip, rehire, reinsure, retrain, and reestablish supply chain contracts to meet exploding demand in the face of shifting COVID -19 regulatory guidance. In other words, their inventories and supply chains were derailed. As I’ve written about before, it’s a lot easier to turn the economic machine off than it is to turn it back on. It’s not to say that this won’t be fixed…Americans are doing what we always do which is innovate and create, but these things take time.
To create time and space for the supply side to recover, the Fed can curb demand by manipulating interest rates. By making the cost of capital more expensive to borrowers, tighter capital means less spending. This is called contractionary monetary policy because it slows the economy. The cost of servicing loans grows higher. As loans become more expensive, consumers and businesses borrow less. This slows down the economy. Less spending means more time for suppliers to rebuild inventories so market forces can begin normalizing prices. The fed funds rate is the average interest rate banks pay for overnight borrowing in the federal funds market to bolster their reserves. The Federal Reserve can alter this rate to influence other interest rates, such as credit cards, mortgages, and bank loans. Since the COVID crisis began, the fed funds rate has hovered between 0% to 0.25%. This made the cost of capital extremely cheap. In other words, you could effectively borrow money for “free” relative to historical norms. To combat demand, the Fed will be raising rates.

Bond Market

So what is the bond market telling us about the scale of those rate increases? The chart below shows the 2-year Treasury yield compared to the fed funds rate. If you consider that the Federal Reserve typically raises rates in .25% increments, you can see that the bond market is “pricing in” about six hikes in the near-term. 
We do see the arguments for a .50% rate hike in March. The level of the funds rate looks inappropriate, and the combination of very high inflation and strong wage growth deserve to be taken seriously. So far though, most Fed officials who have commented publicly have opposed a .50% hike in March. Based on previous comments of sitting FOMC members, we therefore think that the more likely path is a longer series of .25% hikes instead.  For now, the Fed has some catching up to do with the bond market. All eyes will be on the Federal Open Market Committee when they meet again in March to decide the course of short-term rates. 

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