It has to do with a strong economy
Guess what? Interest rates can go up. The Federal Reserve believes the economy is fit enough that it is time to start weaning it off the massive stimulus it has injected into the system. It’s good news ? The answer is, of course, yes.
Is the economy really in good shape? Yes it is. Growth is strong. In the spring and summer, the percentage increase was the second largest on record. Better yet, the level of activity is now above what it was when the pandemic hit.
In addition, the country’s unemployment rate has plummeted, falling nearly 10 percentage points from the pandemic peak in April 2020. Job gains are robust and there are more vacancies than there are. unemployed people.
In other words, the economy is back. And this is essential, because the Fed has a double mandate: a maximum of sustainable jobs and stable prices.
The maximum share of sustainable employment seems in sight, but stable prices? I’m not so sure.
Strong growth coupled with high inflation underscore the tensions in the Fed’s mandate: Sometimes a rapidly expanding economy can trigger price increases. When you add a collapse in the global supply chain to robust economic activity, you have real consumer price issues. Inflation is well above the Fed’s target by an average of 2%.
So what does a good central bank do when the economy no longer needs its help and inflation starts to show its ugly head? Increase the rates.
And this is the path the Fed has embarked on.
When the pandemic struck and the economy collapsed, the Fed used every tool at its disposal. He lowered the rate he controls, the federal funds rate, to close to zero, and all the other rates followed.
The Fed also turned on the liquidity tap, buying massive amounts of securities. It added over $ 4 trillion to its balance sheet and ultimately to the economy. One of the reasons the stock market has surged is the huge influx of funds not only into the economy, but also into the financial markets.
With the recovery well established, it was time to rethink the policy. At the September meeting of the Federal Open Market Committee (FOMC), the Fed’s rate-setting group, it was announced that “if progress continues broadly, as expected, the committee considers that a moderation of the pace asset purchases may soon be justified. . “
In other words, the Fed is starting to withdraw from the economic support business.
What does this mean for the average person? It starts with interest rates and extends to the general economy and markets.
The purpose of the purchase of securities was to lower interest rates on all assets, from the very short term, such as three-month Treasury bills, to the long term, such as 30-year fixed-rate mortgages. . The Fed has done a fantastic job, and rates are still at or near their historic lows.
By reducing its asset purchases, and most likely selling later, the Fed will end the downward pressure on rates. Interest rates are likely to rise.
The reduction in asset purchases is not the only reason that interest rates are expected to rise. At its last FOMC meeting, the Fed said it could start raising the funds rate as early as the end of next year.
When the Fed signals an upcoming policy change, the markets respond. If, as expected, the economy remains strong and inflation continues to be high in 2022, the Fed will most likely raise the funds rate, and the markets will follow suit.
Is Rising Interest Rates Bad? It depends on why they are increasing.
The Fed’s actions to start the rate hike process are based on the reality that the economy is able to stand on its own. The massive stimulus measures by the Fed and the federal government pulled us out of the recession and supported the robust growth we’ve been enjoying for over a year. This help is no longer needed, so the Fed’s actions are a positive sign.
But rising rates mean the cost of consumer and business borrowing is rising. Payments on new mortgages, auto loans, construction and investment loans all go up when rates go up. And this has a restrictive effect on economic growth. As far as the Fed is concerned, however, it’s not bad. With inflation skyrocketing, he wants growth to moderate so that price increases slow.
There is also a potential impact on the stock markets. Some of the liquidity found its way into the equity markets and supported the rapid rise in prices. This support will weaken and could be reversed.
In addition, higher rates influence stock prices. The price of a stock depends on the value of returns that an investor gets over time. This stream of returns must be valued in today’s dollars, and to do this, interest rates are used to find what is called the present value. The higher the rates, the lower the value of future income and the lower the current price of an asset.
This means that rising rates can spill over into the stock markets. I’m not saying the markets are going to fall. They don’t have to do it if incomes remain high. But it does indicate a potentially slower rate of increase in stock prices.
Higher rates are coming. They have to, because current levels don’t make sense. Think about it: if you buy a 10-year treasury bill that pays 1.5%, but inflation on average hits the Fed’s target of 2% over those 10 years, you are losing purchasing power. every year.
Yes, higher tariffs create costs for consumers and businesses. But they are also sending the message that the economy is back. We should recognize this as something good.
Joel L. Naroff is the president and founder of Naroff Economics, a strategic economics consultancy in Bucks County.