Fed maintains the pace

A perspective from E*TRADE Securities 07/27/22

On Wednesday afternoon the Federal Reserve announced it was raising interest rates by 0.75%, matching last month’s increase and bringing the Fed funds rate to a target range of 2.25%–2.5%—its highest level since December 2018:

Chart 1. Fed funds rate, July 1992–July 2022

Source (data): Federal Reserve (www.federalreserve.gov). Reflects 0.75% hike announced 7/27/22. (For illustrative purposes. Not a recommendation.)

After the central bank raised rates by 0.75% in June—its biggest increase since 1994—most market watchers looked for an equivalent hike this month. But after the July 13 Consumer Price Index (CPI) showed inflation was at its highest annualized level since December 1981, speculation grew that the Fed would possibly raise rates by a full percentage point.

When the Fed raises interest rates, auto loans, credit card rates, and mortgages become more expensive for consumers, while businesses also pay more to borrow the money they need to fund operations or expand. That can make both consumers and businesses more conservative about spending—which may then cool the economy and, hopefully, drive down the prices of goods and services. The Fed’s ongoing challenge is to accomplish this goal without tipping the economy into recession.

The following chart shows the S&P 500 (SPX) rallied for nearly two weeks after the Fed’s March 16 rate hike, fell after the May 4 increase (although it closed sharply higher the day of the announcement), and began rallying two days after the June 15 hike:

Chart 2. S&P 500 (SPX), 2/23/22–7/26/22

Source: Power E*TRADE. (For illustrative purposes. Not a recommendation.)

While the immediate outcome of a Fed rate hike is often heightened volatility, the longer-term correlation between rising interest rates and falling stock prices is not as strong as many people think. For example, the SPX rallied during the last two Fed tightening cycles (June 2004–June 2006 and December 2015–December 2018).

However, Morgan Stanley Wealth Management has argued the US stock market’s recent stability (through Tuesday, the S&P 500 was up roughly 7% from its June 16 low) may have reflected investor hopes that inflation was peaking and that businesses would be able to pass on rising costs to consumers to shelter margins.1 But as they noted, historically, corporate profit declines (and stock market declines) have sometimes followed other periods of high inflation and aggressive rate increases. Some of their recent observations about investing in a rising-rate environment can be found here.

Interest rates changes are important, and they often move the market, but they shouldn’t derail a long-term plan. Investors need to remain even-keeled in their approach, starting with a balanced, diversified portfolio that reflects personal goals and risk tolerance levels.

Note: The Fed’s next policy meeting is scheduled for September 20–21.

 1 MorganStanley.com. The Critical Data Some Investors Are Ignoring. 6/10/22.

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