Inflation, Interest Rates, and the Federal Reserve
Inflation, Interest Rates, and the Federal Reserve
Inflation can be defined as a general increase in prices and a decline in the purchasing value of money. If not kept under control, inflation could hamper economic growth and result in reduced living standards for individuals. Today, there are still high levels of inflation in the U.S. economy. Some of these are more temporary than others. According to CNBC, Americans are now paying the most they have at the gas pump since October 2014. In addition, the average price for a regular gallon of gasoline in the U.S. is currently 55% higher than it was just one year ago. Other areas, such as lodging and travel, are proving to be more transitory and related to the initial surge in demand following the economic re-openings from the COVID-19 pandemic.
Regardless of whether inflation is or isn’t transitory, inflation, overall, is surging. Consider that the consumer price index (CPI), a widely recognized barometer of inflation, rose 6.2% on a year-over-year basis in October, marking the highest annual gain in 31 years! This record level of inflation presents challenges to economic recovery and has become a major concern to consumers across the country. This concern is evident in the November reading of the University of Michigan Consumer Sentiment Index, which plunged to 66.8, its lowest level in a decade. The survey showed consumers expect even higher inflation rates ahead, with the 12-month forecast moving higher to 4.9%.
With inflation being so high and economic growth remaining so strong (for now), many investors are properly questioning why the Federal Reserve (Fed) is not moving quickly to raise interest rates? To answer this question, we should first understand that the Fed currently believes that inflation will begin to moderate in 2022. Secondly, we must put interest rates in the context of the Federal Reserve’s overall “TNT” approach to handling inflation, promoting full employment, and helping the economy fully recover from the COVID-19 pandemic.
• Taper – scale back their current bond purchases of approximately $120 billion a month. Early in November, the Fed announced that they would begin their gradual tapering plan later this month by purchasing $ 10 billion less of U.S. Treasuries and $5 billion less of mortgage-backed securities each month.
• Narrow – shrink the current size of their $8 trillion + balance sheet through the sale of bonds. Fed Chair Powell indicated that the Fed wants to start the Taper process first before considering shrinking the enormous size of the Fed balance sheet. Until this consideration, $105 billion a month in additional bonds (as a result of the early November announcement) will continue to increase the size of the balance sheet until further tapering commences.
• Tighten – raise the Fed Funds Target Rate from its current range of 0.00% – 0.25%. Despite some on Wall Street calling for two rate hikes of 25 Bp (i.e., 0.25%) each in 2022 and two additional rates of 25 Bp each in 2023, we find ourselves tending to agree with the most recent “Dot Plot” Chart (see below) from the Fed suggesting one rate hike of 25 Bp in 2022 and 3 potential, additional rate hikes of 25 Bp each in 2023. As a means of background, the “Dot Plot” chart is published quarterly and summarizes the Federal Open Market Committee’s (FOMC’s) outlook for the federal funds rate.
While it is clear from the chart above that we are heading into a rising rate environment; interest rates are still likely to stay at historically low levels for the foreseeable future. In addition, rising rates should accompany the continued expansion of the U.S. economy. Otherwise, the Fed would not consider raising interest rates.
Investors should not necessarily fear inflation nor be scared about rising interest rates during this economic recovery, but rather should plan and position their investment portfolio strategies, accordingly, always being mindful of their growth and/or income objectives, investment timeframe, and risk tolerance. For example, areas of the market that have performed relatively well during previous periods of economic expansions, that may have coincided with rising rate environments, include, but are not limited to, U.S. and international equities, high yield bonds, and certain investment-grade bonds such as municipal bonds.
Inflation, interest rates, and the Federal Reserve are just a few of the many moving and often confusing pieces of the capital markets puzzle. As a result, we recommend that investors work with experienced investment professionals to evaluate these moving pieces and help build and manage the asset classes within their investment portfolios.
Happy Thanksgiving, everyone!
Hennion & Walsh Asset Management currently has allocations within its managed money program, and Hennion & Walsh currently has allocations within certain SmartTrust® Unit Investment Trusts (UITs) consistent with several of the portfolio management ideas for consideration cited above.
Past performance does not guarantee future results. We have taken this information from sources that we believe to be reliable and accurate. Hennion and Walsh cannot guarantee the accuracy of said information and cannot be held liable. You cannot invest directly in an index. Diversification can help mitigate the risk and volatility in your portfolio but does not ensure a profit or guarantee against a loss.