• Mike Komara

Will the Fed Raise Interest Rates Sooner than Expected?

Inflation refers to the rate at which the prices of goods and services rise and the currency's purchasing power declines. For example, as prices rise, the dollar's purchasing power falls. Interest rates are the amount lenders charge borrowers for loans. They are based on the fed funds rate set by the Federal Reserve, also called the Fed.

Inflation and interest rates have an inverse relationship. When interest rates are low, borrowing money is easier, and consumers spend, causing prices to rise and creating the potential for inflation. When interest rates are high, borrowing money is more costly and savings interest rates are higher, so customers save more and spend less. Prices then decline.

The Fed uses the inverse relationship of interest rates and inflation to manage the economy. The way the Fed manipulates short-term interest rates to prevent or manage recessions and inflation.

Reasons the Fed might raise interest rates sooner than we thought.

Inflation Rates

The Fed indicated late last year that it would raise the interest rate three times this year. The inflation rate has continued to accelerate since then, rising above market predictions and to a higher rate than in about 40 years. Food and energy prices are the primary drivers of these increases. The higher-than-expected inflation could mean that a fed funds increase is imminent.

On the other hand, the bulk of the price increases is for products that typically are highly sensitive to economic factors. The Fed calls these "flexible" priced goods. Flexible priced goods include motor fuel, natural gas, used cars, hotels, and rental cars. Goods that tend to have more stable prices include rents, communications, medical care, and apparel. These are called "sticky" priced goods. Sticky prices are more often linked with long-term inflationary expectations.

Sticky prices are rising, but they are doing so at a much lower rate than flexible prices. The Fed will weigh the sticky price increases more heavily when considering when and how high to raise interest rates. Because sticky prices are not rising dramatically, the Fed may hold off on raising rates.

Market Effects

Stock and bond market expectations of a fed fund rate increase currently seem to be running ahead of the Fed in the United States and other markets worldwide. These markets are acting as if they believe a rate hike is imminent. Stock benchmarks are falling, and government bond markets are increasing. Market reactions could influence the Fed to act.

Fed Behavior

For several months, the Fed has been buying up a significant number of bonds to encourage the economy to bounce back after pandemic closures. Since the first of the year, the Fed has begun tapering off its bond purchases and has indicated they will cease this spring, citing inflation. Minutes from the Fed's December meeting indicate that they are considering raising the interest rate at about the same time as these purchases stop.

Effects of Raising Rates

While raising rates would likely lower the inflation rate, it probably will not completely solve all inflation issues. Prices rise based on supply and demand. When the supplies of a good are lower than its demand, prices rise. Supply chain bottlenecks have caused many goods to be in short supply. Until these bottlenecks resolve, the prices of some goods will remain high, regardless of the Fed's interest rate actions.

The Fed's actions will likely affect the prices of stocks and other assets. Low interest rates and the Fed buying back bonds tend to benefit the market. .

The Bottom Line

A hike -- or several incremental hikes -- in the federal funds rate is likely some time soon. The amount of the rate increase depends upon how well the economy begins to stabilize on its own. Also, because supply issues are driving some price increases, the Fed's actions will not be a complete panacea.

The team at Solas Wealth can help you understand how the Fed's actions can affect your finances and portfolio in the short-term, midterm, and long-term future. Our customers' portfolios automatically adjust to market changes, and we construct them to protect customers from downtrends. Fill out our contact form online today to schedule a conversation with one of our team members.


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