Walking a Tightrope – Federal Reserve Edition

The Federal Reserve is making a U-Turn with an aggressive approach that will include interest rate increases.

The Federal Reserve is returning to the forefront of conversations in an economy that has largely recovered from COVID, and it’s making a U-Turn. Unlike last Saturday’s Super Bowl, where there could only be one winner, the goal is to have everybody win as the Fed starts to walk the tightrope between inflation and deflation by increasing interest rates.

Episode Transcript:

Hi everyone, Jay Pluimer here with Flourish Insights. As the director of investments at Flourish Wealth Management, I take pride in providing our clients, colleagues, and friends with resources and information that can help them make strategic and effective choices regarding their investments. Did you know we have an Alexa Skill? To listen on your Alexa device, just say, “Alexa, play Flourish Insights.”

Today, we’re discussing how to Walk a Tightrope, the Federal Reserve Edition

Recording this episode of Flourish Insights on Super Bowl Sunday is a little ironic based on the topic. The Super Bowl can only have one winner, the LA Rams or the Cincinnati Bengals. However, the goal is to everybody win as the Federal Reserve starts to walk the tightrope between inflation and deflation by increasing interest rates.

As discussed during recent episodes of Flourish Insights, the US Economy is currently experiencing the highest inflation rates in a generation. Year over year inflation rates have been at or above 7% for the past 3 months. A portion of that high number can be explained by comparing a mostly open economy with multiple effective COVID vaccines today against a time period in late 2020 and early 2021 where we were still exploring what a post-covid economy would look like. Although there are still significant headwinds and we definitely aren’t out of the woods with COVID, higher prices reflect a rapidly growing economy with low unemployment rates, increasing wages, and people going back to work. We have also continued to experience strong consumer spending as most American families have less debt and more cash to spend than they did 12 months ago. There are still supply shortages and logistics obstacles that need to be worked out, but the consensus is that inflation will remain high for the foreseeable future unless something slows it down.

The Federal Reserve, led by Chairman Jay Powell, is returning to the forefront of conversations about the economy because they are in the process of making a U-Turn, transitioning from being patient and passive while the economy recovered, to a much more aggressive approach that will include interest rate increases. As a reminder, the Federal Reserve cut interest rates from 2% to 0% in early 2020 to support the economy during the COVID shutdown. Lower interest rates are described as “stimulative” because they support economic growth in a variety of ways. A few examples of how lower interest rates work is that they decrease the cost of debt, helping companies borrow money from banks and investors to keep their business running or even expand while paying very little interest. Individuals and families benefit in a similar way with lower mortgage rates to support the purchase or refinancing of homes. In addition, earning 0% in your checking account means people are more likely to spend money instead of saving it, including putting more money into the Stock market. A Zero Interest Rate Policy, also known as ZIRP, is the most aggressive response available to the Federal Reserve to support economic growth and consumer spending.

This is also when Jay Powell started to walk a tightrope between inflation and deflation. We know that inflation can be bad if prices get too high and families can no longer afford basics like food, transportation, and clothing. But deflation is even worse because it means prices are falling so fast that companies are laying off employees and people will struggle to make ends meet. I don’t envy the role that the Federal Reserve will play over the next couple of years, because a misstep in either direction will mean an economic crisis.

The Federal Reserve has committed to increasing interest rates in March, just a few weeks away from when I am recording this episode. Most experts predict that the Fed will raise interest rates 4 times this year and a total of 7 to 9 times over the next two years. Higher interest rates will reduce corporate and individual borrowing, slow down rising prices in the housing market, and potentially pause wage growth. The bond market has already started to price in the first year of rate increases which has sparked some of the recent market volatility because investors are being forced to re-evaluate future growth rates for stocks, the potential opportunity to invest in bonds, and even opportunities to keep money in cash accounts.

I picture the tightrope walk to being similar to watching a circus performer or the movie “Man on Wire”. It’s relatively easy at the start because the rope is close to the anchor and the performer is fresh with lots of energy and patience. That should describe what we will see during 2022, with the only danger being a potential 50 basis point increase at one of the Fed meetings this year because the market is expecting that each hike will be in 25 basis point increments.

The tightrope will start to look thinner and have more sway as we enter 2023. At that point, inflation should be decreasing but economic growth rates should still be around 2% or better. That’s a sweet spot for the economy. The winds trying to knock the performer off the tightrope will be unemployment levels, wage growth, and consumer prices. Failing to increase rates substantially enough will mean a period of prolonged inflation, which is dangerous. However, this is also when the Fed will start to face the opposite risk that raising interest rates too high and too fast will create momentum for a deflationary environment. We should expect to see people pulling their money out of the stock market, starting with highly speculative investments, and buying safer investments with attractive yields. A bond yielding 3 or 4 percent can be pretty attractive if inflation is close to zero. Another factor that the Fed will need to consider at this point is the voices of the crowd, some screaming to stop raising interest rates while others are yelling that higher interest rates are absolutely necessary. This is when I envision the tightrope performer starting the walk from the bottom of the rope to the far side, balancing against falling to either side while also finding balance between falling forward or backward.

We won’t know whether or not the Fed has successfully walked the tightrope until mid- or late-2023, with the true results showing up a year or two later based on economic growth rates, inflation levels, and unemployment rates. At this point, it’s important to understand the balancing act the Fed is walking, what they are trying to accomplish, and knowing that a successful trip across the tightrope means that we all benefit from lower inflation while still having economic growth. I send my best wishes for success to Jay Powell and the rest of the Federal Reserve as they attempt to walk this dangerous tightrope!

For more up-to-date insights into the market, the economy, and what it all means for your portfolio, subscribe to Flourish Insights on Apple Podcasts, Spotify, or wherever you listen to podcasts. You can also find our full catalog of episodes at FlourishInsights.com. Thanks so much for listening, and don’t forget to stay focused and think long-term.

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