On Wednesday, July 26, 2023, the Federal Reserve raised the federal funds rate from 5.25% to 5.50%. This marks the highest interest rates have been since 2001. There have been 11 interest rate hikes so far in this cycle. This was not a surprise, with many analysts expecting this hike after the pause in June. Analysts predict an additional 0.25% rate hike (25 basis points) to occur this year. Fed Chair Jerome Powell has said they will review potential rate hikes at a meeting-by-meeting basis and make data-driven decisions.
This does not mean the market will drop or the economy will enter a recession. In fact, it’s important to note that the U.S. economy grew at a 2.4% annualized rate as of the end of June, 2023. Actions by the Federal Reserve have been aimed at reaching their target inflation rate of 2%, which we have not yet met. Overall inflation (the inflation of all goods) as of June 2023 was at 3% while core inflation (the inflation of a basket of goods that excludes volatile things such as food and energy) is at 4.8%, sitting above overall inflation. This is because food and fuel prices are volatile in both directions. The cost of these commodities has dropped quicker than other goods, meaning consumers at the grocery store and the gas pump are seeing prices rise less than they were in 2021 and 2022.
While hiking interest rates does increase the cost of borrowing for companies, individuals and even the US government, the long-term effects of increased interest rates can be positive on the economy and on investor returns. Higher interest rates mean bonds issued today will pay higher interest than bonds issued at lower interest rates a year ago. Additionally, when these rates drop, bonds that were issued at higher interest rates become more valuable due to their higher coupon payments. Higher interest rates also give the Federal Reserve an additional tool to fight against recessions. When the economy slows down and a recession may occur, decreasing interest rates is one tool used to speed up the economy by making it easier to borrow money. When interest rates are already low and a recession is looming, an economy has less options to attempt to avoid it.
Jack O’Brien CIMA® is a Certified Investment Management Analyst educated at Chicago Booth School of Busisness and Virginia Tech. EVOadvisers is a fee-only financial advisor based in the Scott’s Addition area of Richmond, Virginia. EVOadvisers also has an office in Irvington, Virginia to better serve clients in the Northern Neck of Virginia. If you have any questions about financial planning and would like to talk with one of our Certified Financial Planner professionals, check us out at www.evoadvisersdev.wpengine.com or call (804)794-1981.