The Fed's Rising Expectations for Interest Rates

The last time I recall writing about the Federal Open Market Committee’s (FOMC) forecasts was in 2019. Yesterday’s 75-basis-point (0.75%) increase—the first triple quarter-point hike since 1994—warrants an updated discussion.

The individual forecasts of committee members are made public four times a year. Yesterday was one of those times. You can see the individual forecasts plotted on a chart as individual dots. Hence the references to the “dot plot.”

The dot plot currently shows a median expectation for the federal funds rate to be 3.4% this year and 3.8% next year, versus a range of 0.0% to 0.25% this past January. The target rate is projected to pull back to 3.4% in 2024. As you can see on the chart to the right, there is quite a bit of variance between the low and high forecast for 2023 and even a bigger variance for 2024.

When we look specifically at the past six months, the magnitude of the shift in expectations can be seen. Here are the median 2022 projections for the federal funds rate from FOMC members:

• December 2021: 0.9%;
• March 2022: 1.9%;
• June 2022: 3.4%.

The key reason is well-known: inflation. The FOMC’s projections of 2022 personal consumption expenditures (PCE) inflation have been revised upward from 2.6% in December 2021 to 4.3% in March 2022 and 5.2% this week. Federal Reserve chair Jerome Powell described inflation risks as being “weighted to the upside” in his prepared remarks at yesterday’s press conference. Supply chain issues, oil and grain disruptions attributable to Russia’s invasion of Ukraine, China’s coronavirus-related shutdowns and the tight labor market are all contributors.

Inflation has been both stickier and stronger than Powell and other FOMC members have expected. Though there never seems to be a shortage of criticism thrown in the Fed’s direction, it’s important to realize that the FOMC members have access to a great deal of information and a staff of economists. Even with all the data and analysis, they’ve still misjudged the persistence of inflation. Furthermore, the record of the Fed successfully orchestrating economic soft landings has not been good.

(There is a long record of monetary policy and how the economy has performed after policy announcements. The same cannot be said for many forecasters and pundits who speak or write with more confidence than they should. Forecasts are fallible and everyone is using cracked crystal balls.)

Implications of the Interest Rate Hike for Individual Investors

A potential silver lining exists for those of you who have been waiting a long time for higher interest rates on your savings. Banks won’t raise their interest rates in lockstep, but the rate hikes should help. The interest rate paid on my Discover savings account has risen from 0.45% at the start of this year to 0.95% today. (This rate is available to all AAII members; go to www.aaii.com/discover for more information.)

Bond yields have been rising since late May. Those of you who have laddered bonds have the chance this year to reinvest the proceeds of maturing securities at higher interest rates. It’s the same with certificates of deposit (CDs).

For borrowers with variable interest rates, the news is not great. This is particularly the case for those with credit card debt. The best thing you can do is to pay down the debt as quickly as possible. The second-best thing would be to see if a balance transfer at a lower rate would make sense. (Be sure to read the fine print regarding the terms.)

In terms of stocks, the rate hike is also a mixed bag. Mr. Market wants the Fed to keep inflation from getting out of control. Tightening monetary policy too much and too quickly runs the risk of triggering a recession. Higher interest rates also prompt investors to demand higher expected returns as compensation, which in turn lowers stock prices.

We’ve seen this repricing of equities occur over the past couple of months—and certainly today. These adjustments do not occur in a vacuum—traders also weigh many other factors—but they do occur. Most importantly, the market tends to be forward-looking.

Finally, remember that investing is a long-term exercise. As investors, we don’t get to choose the market and economic conditions that exist throughout our lifetimes. We do get to choose how we react to them. The returns from following a disciplined approach are always likely to be higher than the returns from making decisions based on what you think might happen.