Rising Interest Rates

Q: The Fed is aggressively raising interest rates. What does that mean for investors?

A: Inflation is setting 40-year records. It increased through June to a high of 9.1%, even higher than the consensus prediction of 8.8%. That’s a big deal.

Inflation is also one of the major economic concerns that the Federal Reserve is specifically tasked to control. Through the Federal Reserve Act of 1977, Congress explicitly ordered that the Fed’s goals should be “maximum employment, stable prices, and moderate long-term interest rates.”

Plus, from a Fed policy perspective, we frankly remained too accommodative with both monetary and fiscal policy for too long. To some extent, that was unavoidable; the pandemic forced everyone’s hands. But now we need to course-correct, because policy that’s too accommodative can start leading to undesirable and unexpected market events. As I wrote last year:

“When monetary policy is very lax and accommodative, and you have a lot of money that lands in a lot of checking accounts, then the by-product is Robinhood/GameStop fiascos. Cryptocurrencies that have no business at all being in the market that are trading at ridiculous prices overnight. An NFT market that no one had even heard of nine months ago, and now it's being bid up for jaw-dropping amounts of money.”

So, the Fed aggressively addressing inflation and finally ending their accommodative stance makes sense to me.

But will they go too far?

There is some evidence that we may be past the worst of the inflation. Jeremy Siegel, an economist and professor of finance at the University of Pennsylvania’s Wharton School of Business, told CNBC’s Halftime Report, “I think most of our inflation is behind us.”

That said, there are enough unknowns in the system, especially from a geopolitical perspective, that it’s hard to make predictions. For example, Europe’s sixth package of sanctions against Russia for its invasion of Ukraine includes a ban on all Russian crude oil delivered by sea by December and all Russian refined products two months after that. Will it actually meet those self-imposed mandates? If so, how will that impact global oil supply and costs?

But right now, commodity prices are rolling over. As the expression goes, the cure for high prices is high prices. These markets don’t stand still, and prices for commodities ranging from gas to copper have fallen in the past month, suggesting that inflation is slowing again.

If that’s true, the concern becomes that overly aggressive interest rate hikes could send the country into a recession. Raising interest rates will indisputably cool off some inflation by curbing demand, but that will also slow down the economy.

The balancing act for the Fed is making sure they can accomplish both their employment and inflation goals at the same time, which is a hard thing to do. Even they acknowledge it’s a tough goal to score: back in May, Federal Reserve Chairman Jerome Powell described the ideal soft landing as “quite challenging.”

Remember, as powerful as the Federal Reserve may be, it works with a limited toolset. It's using policy to either stimulate or curtail demand, whereas it’s the supply side that is more of a determinant in some current prices.

Consider energy: we didn't really have the will to invest in energy infrastructure, and geopolitical events (Russia invading Ukraine) have additionally triggered supply constraints. There’s not much the Fed can do about those issues.

Is a recession likely?

Maybe. I’m not an economist who prognosticates about future market states. I will say that, if there is a recession, it would likely be mild. I wouldn’t expect anything like the 2008/2009 situation.

Former Federal Reserve Bank of New York President Bill Dudley agrees. "You really get a deep downturn when things in the financial system break – I don't expect that to happen this time," he said on Bloomberg Television. "I would expect a mild recession like 1990 or 2001, not a deep recession like '73-'74."

“There is a good chance [if] we do suffer a recession, [that] it will be less severe than a typical one,” Mark Zandi, chief economist at Moody’s Analytics, similarly told CNBC.

You won’t necessarily see those sentiments reflected in headlines, though. Fear sells, and the media has a bad habit of playing up economic downturns. Consider the infamous “Amazon.bomb” headline in 1999 during the dot com bust.

The truth is, while we face an increased risk of recession due to the Federal Reserve aggressively raising interest rates and thus slowing demand in the economy, the underlying fundamentals of the economy are strong. Our banking situation is healthy, there isn't a level of excess, and undue asset valuations have come down. The employment situation is a mixed bag, but consumer balance sheets are strong.

No one loves a recession, but we’re relatively well-positioned for one. I agree with the above assessments that if we do end up going through a recession, it will likely be milder than average.