Recent investment news has focused on the Federal Reserve(Fed) raising interest rates to combat inflation. So, what does that mean and how might it affect average Americans? The Fed was established by congress in 1913 in an effort to create a stable banking system. It was initially given three main purposes, two of which being to stabilize prices and moderate long-term interest rates. As we shall see, the two are intertwined.
High inflation can devastate an economy, and especially the middle class. Rising prices create a rush to buy before they go up further, which then pushes prices up faster in an accelerating upward spiral. The higher prices mostly affect middle America who lose purchasing power even as their wages are rising. The recent real estate market has shown the effects of rapid inflation with rising prices attracting wealthy investors who snatch up homes to protect their wealth, while pricing out the people who need those homes to live in.
Since the Fed is tasked with stabilizing prices, one way to reduce inflation is to make it more expensive for people and businesses to borrow money. Higher borrowing costs are designed to slow down purchasing and cool inflation. The Fed does not directly control consumer interest rates, but they have a tool that allows them to affect those rates. It is called the Fed Funds Rate and it is the rate banks charge each other. Banks are required to maintain minimum cash reserves, but cash doesn’t earn anything, so they don’t want to hold more than necessary. To maintain proper levels, banks borrow money from each other at the daily fed rate. As the Fed raises that rate, they force banks to increase loan rates to their customers to cover the costs. Customers who pay higher interest will borrow less, spend less, and reduce inflationary pressure. The ironic effect as it relates to home mortgages is that higher interest rates increase the cost of home ownership. The Fed is essentially trying to reduce prices by increasing them. This is a delicate balancing act that doesn’t always work as planned, and that is likely the main reason Wall Street is concerned. What most investors fear more than interest rates is uncertainty.
To keep all this interest rate fuss in perspective, the Fed has only raised its daily rate to a very mild 1.5 %. Since 1913 the Fed funds rate has averaged significantly higher than that, going over 20% in 1980. The current moves are designed to get interest rates back to more historical norms. The challenge the stock markets are having now revolves around the uncertainty of whether this action will have the desired effect on inflation without harming the economy in other ways. Once inflation begins to retreat, I expect to see a better mood on Wall Street with less concern about what the Fed is doing. When inflation starts to come down, I wouldn’t be surprised to see a significant market rally.
Dan Wyson, CFP® is author of “The Gold Egg,” and “21 Financial Myths” and owner of Wyson Financial/Wealth Management 375 E. Riverside Dr. St. George, UT 84790 – 435-986-9525 – Securities and Advisory services offered through Commonwealth Financial Network, member FINRA/SIPC, a registered investment advisor