The Fed is raising rates at a furious pace to try to stem inflation. Here's what investors need to know.
Imagine the following. You are driving toward a stoplight. There is a line of stopped cars, but you are still a long way away, and instinct tells you that by the time you get there the cars will have accelerated and gone through the light. You keep speeding toward the light, but the cars do not move. Maybe the light was a long one. Maybe the driver in front was slow to react. Maybe the line was longer than you estimated. You slam on your brakes late to avoid a collision. How embarrassing! Now you have to hope the cars behind you have time to stop as well, for their own sake and yours. Why didn’t you simply slow down when you first saw the line ahead?
So it has been with the Federal Reserve applying the brakes too late after inflation failed to resolve itself as the Fed hoped.
Now the Fed has to raise interest rates rapidly to hold back inflation, with the risk of causing damage in its wake. The Federal Funds rate is currently at 2.5% and expected to rise to 4% by the end of the year. That is well below the trailing rate of core CPI inflation but is slightly above median expectations for 3-year forward inflation, according to a survey by the Federal Reserve Bank of New York. By that measure, short-term rates would be approximately neutral, meaning further hikes in 2023 would be, in theory, restrictive. Forward inflation expectations are volatile and can change based on factors that are hard to model, the hardest being the Fed’s unknown future responses to changing data. As with August’s CPI report, if inflation expectations prove inaccurate, then most of the risk is probably to the upside. The Fed claims it is committed to keeping inflation low, and in 2022 its actions have been mostly consistent with that claim. If its progress has been a little slow then one excuse could be a simple lack of practice. The last time the Fed Funds rate was this high and still rising was way back in 2005.
The U.S. dollar’s strength reflects the Federal Reserve’s relative hawkishness. The dollar is up about 30% against the yen and recently crossed “parity” with the euro for the first time in twenty years, meaning one dollar became more valuable than one euro. Arguably, parity is merely a psychological concept. The euro going from $1.01 to $0.99 is not intrinsically different from going from $1.07 to $1.05. Psychology has meaning though, and it may not be a coincidence that the ECB was finally motivated to start raising rates after its currency crossed a key psychological threshold.
The U.S. is relatively lucky that its primary economic concern right now is simply balancing the risk of inflation against the risk of recession. A little of either, or a little of both, should not be cause for grave concern. Most other major economies seem destined for both, to the point where “contagion” becomes a salient risk for the U.S.—that is, the risk that international weakness spills over. Again, however, the good news is that when you are worried about contagion, that means the center of weakness is somewhere else.
It is a good time to remember that stocks are real assets, backed by the value of the business operations they represent. Fundamentally, it does not matter what currency those businesses keep their accounts in. Inflation harms stock returns through the secondary pathway of higher rates. Bonds offer no inflation protection.
As always, we preach the merits of growing, high-quality companies like the three companies profiled in the October 2022 issue of the Investor Advisory Service. When you build a portfolio around equity in solid businesses like these, at least you know where you stand, whatever central banks are up to.
This commentary originally appeared in the issue of Investor Advisory Service published in late September. To receive this information in a more timely matter and receive two or three stock picks each month
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