March 13, 2022
The war in Ukraine will likely raise prices of energy, food, and other goods for US consumers and businesses. Both Russia and Ukraine are major producers of not only oil and gas, but also of wheat, corn, and other commodities used in a wide variety of products. Now, violence and resulting economic sanctions against Russia threaten to reduce exports, further strain global supply chains, and raise prices far beyond the 2 countries’ borders. These new inflation pressures come as the US already struggles with its highest inflation rates in more than 40 years and further complicate the challenge that the Federal Reserve faces as it begins to raise interest rates in hopes of stabilizing prices without hurting economic growth.
Fed Chairman Jerome Powell has said that high inflation makes it appropriate for the central bank to raise the federal funds rate at its March meeting but he has also said it’s too soon to tell how war in Ukraine may affect the US economy. In the past, geopolitical crises have caused the Fed to hold off on raising rates, but this time the central bank won’t postpone plans to increase rates from the historic low where they’ve been for the past 2 years. Instead, with geopolitical uncertainty rising, the Fed is likely to go ahead more gradually than markets may have previously expected.
What is the Fed doing—and why?
The Fed’s mission is to help maximize employment and ensure stable prices of goods and services and it does so primarily by moving interest rates up and down in response to economic conditions. Since March 15, 2020, the interest rate that banks charge each other for overnight loans has been set at between 0% and 0.25%. That rate is called the federal funds rate and it has a significant influence on the economy and financial markets as well as on interest rates on mortgages, credit cards, and other loans made by banks to consumers. The Fed raises and lowers the rate to control the supply and cost of money circulating in the economy.
The Fed’s leaders are concerned that prices are rising too rapidly and they hope that raising borrowing costs will slow spending and reduce inflation. They expect inflation to drop below 3% by the end of 2022 but have expressed concern that with current inflation near 7%, companies might raise prices and wages, which could prolong higher inflation. Their goal is to eventually raise the federal funds rate, likely as high as 2% by 2024 through a series of gradual rate increases. As recently as last week, markets were expecting 6 increases, starting with a 0.5 percentage point rise in March and a series of 0.25 point increases afterward. Now, though, the initial increase will likely be smaller and only 5 increases are likely, according to Director of Global Macro Jurrien Timmer.
The Fed’s balancing act
In setting interest rate policy, the Fed’s leaders closely watch inflation and employment data but they also consider how financial markets may react to their policy moves. The previous plan to start with a relatively large increase was intended to help reassure markets that the Fed was taking the threat of inflation seriously. But adding a relatively large rate increase to markets already anxious about the Ukraine crisis may now seem less reassuring and more likely to provoke a volatile reaction. The Fed still wants to raise rates far enough and fast enough to slow inflation, but the Ukraine conflict complicates that strategy by adding a potential new source of market volatility as well as inflationary pressures. Even though the US economy is insulated from the turmoil in Ukraine to a great extent and the risk of recession is not high, the Fed appears to have opted to back away from what would have been the largest rate increase since 2000.
Will it work?
The expected pace and extent of this new cycle of rate increases is unusual by historical standards. In the past, the Fed has raised rates—as high as 20% in the early 1980s—to reduce high inflation. This time, though, even with inflation running higher than it has at any time since then, interest rate policy is unlikely to follow its typical historical pattern. “In previous recoveries, rates have been much higher than they are likely to be over the next several years,” says Beau Coash, institutional portfolio manager with Fidelity’s fixed income team. “In the past, the fed funds rate eventually rose to 3.5% or 4%. I don’t expect that’s going to happen this time.”
A recent poll of economists by the Financial Times and the University of Chicago’s Booth School of Business suggested that the Fed may need to do more than this to bring inflation under control. Half of those who responded said the Fed won’t get inflation under control with only 6 quarter-point rate rises this year. 40% believe the federal funds rate would need to be at or above 2% this year for the Fed to achieve its goal, and half of that group said the rate needs to be above 2.5%.
What higher rates may mean for stocks
As rates rise, stocks are unlikely to produce the strong returns they’ve delivered since the 2020 rate cut. Historically, stocks have delivered lower returns immediately after the start of a period of rate increases, but returns have increased over the longer term. Certain sectors have also historically fared better than others when rates rise. Banks and other financial firms, for example, tend to benefit from high interest rates, as they can make more money on loans. As rates rise, fundamentals such as earnings and valuation may become increasingly important.
What higher rates might mean for bonds
Typically, when interest rates rise, prices of bonds that are currently in the market decline while newly issued bonds may pay higher yields. Higher rates may sound good to those who primarily seek yield from their bond portfolios while sounding less appealing to those who own bonds primarily because they want bond prices to rise. But if the Fed can follow this policy of gradual and modest rate hikes, both the benefits to savers and any disappointment felt by other bondholders may be mild. As Coash puts it, “For savers, it should be better, but not great. For borrowers, it’s likely going to be worse, but not horrible.”
Over time, higher rates and a resulting rise in stock market volatility may in turn increase the appeal of bonds as both sources of income and preservers of capital in portfolios. The steep rise in stock prices since 2020 reflected the belief of many investors that low interest rates offered them few alternatives to stocks. As rates and yields on bonds rise, though, they may eventually draw some investors away from stocks. Bond investors can also manage the risks posed to bond prices by higher interest rates by focusing on bonds that have lower duration, or sensitivity to changes in interest rates.
History shows that rate increases may be accompanied by stock market volatility and even sizable pullbacks as in 2018 when higher rates were followed by a brief 20% correction in the S&P 500®. But while wars, sanctions, and inflation may all add to market anxiety, a gradual rise in interest rates is no reason for long-term investors to abandon well-diversified financial plans. Instead, they should maintain perspective on news events and the short term, and focus instead on their longer-term goals. As Timmer points out, “It doesn’t mean you should sell. The market, over time, tends to go up and over the last 2 years, it has gone up a lot. Even if the market were to go sideways for a year after being up 100% in 2 years, I would still count that as a good outcome.”
(Sources: Fidelity Viewpoints)