There is a lot of discussion about the Federal Reserve System (the Fed) raising interest rates and speculation on the number of times rates may be increased this year. What are the implications for you, the markets and the economy when rates increase?

What is the Fed?

The Fed is considered the central bank of the United States. It is considered to be one of the most powerful economic institutions in the United States, perhaps the world. Its core responsibilities include setting interest rates, managing the money supply and regulating financial markets. More specifically, it performs five general functions to promote the effective operation of the U.S. economy and, more generally, the public interest. The Federal Reserve’s five-pronged mission is to:

·         Conduct the nation’s monetary policy to promote maximum employment, stable prices and moderate long-term interest rates in the U.S. economy.

·         Promote the stability of the financial system and seek to minimize and contain systemic risks through active monitoring and engagement in the U.S. and abroad.

·         Promote the safety and soundness of individual financial institutions and monitor their impact on the financial system as a whole.

·         Foster payment and settlement system safety and efficiency through services to the banking industry and the U.S. government that facilitate U.S.-dollar transactions and payments.

·         Promote consumer protection and community development through consumer-focused supervision and examination, research and analysis of emerging consumer issues and trends, community economic development activities, and the administration of consumer laws and regulations.

The people who make decisions for the Fed are those who make up the Federal Reserve Board of Governors (Board of Governors), the 12 Federal Reserve Banks (Reserve Banks) and the Federal Open Market Committee (FOMC). The term “monetary policy” refers to the actions undertaken by a central bank, like the Fed, to influence the availability and cost of money and credit to help promote national economic goals. The Federal Reserve Act of 1913 gave the Federal Reserve responsibility for setting monetary policy in the United States.

The Fed’s changes in interest rates impact monetary policy

When the decision makers at the Fed discuss potential rate increases or feel inflation is high or growth is low, they signal, or actually make,  a change in interest rates. This signal, which is simply an announcement of tentative plans to change the rates, can and often does impact markets. This is like when you drive down the road and see a traffic light — green means go, red means stop and yellow means the green light is about to change to red. When the Fed discusses that there is low inflation or growth, it signals that it may lower interest rates. When they discuss inflation, it means they may increase rates.

When the Fed increases interest rates — the cost of borrowing — it makes consumers and companies more cautious about spending. This is how the Fed, in effect, impacts the economy with its decisions about interest rates.

On January 26th, 2022, Jerome H. Powell, the Fed chair, signaled that a rate increase is coming in March. He cited two reasons. First, inflation has been running far above policymakers’ target. In December 2020, inflation increased by 7 percent, the highest annual increase in 40 years. An increased interest rate is expected to bring inflation back down. And second, labor market data suggest that employees are in short supply. Rates have been near-zero since March 2020. Powell did not disclose how many rate increases officials expect to make this year.

By raising interest rates, the Fed is attempting to cool down an economy that is running “too hot.”

The Fed also influences the federal funds rate

The FED also impacts the economy by increasing or decreasing lending rates or reserve requirements of banks.

The Federal Reserve controls the three tools of monetary policy: open-market operations, the discount rate and reserve requirements. The Board of Governors of the Federal Reserve System are responsible for the discount rate and reserve requirements, and the FOMC is responsible for open market operations. Using those three tools, the Federal Reserve influences the demand for, and supply of, balances that depository institutions hold at Federal Reserve Banks and, in this way, alters the federal funds rate. That is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.

Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates; long-term interest rates; the amount of money and credit; and, ultimately, a range of economic variables, including employment, output and the prices of goods and services.

Two risks to watch out for now

Two of the biggest risks we see for investors today are moving too much money to fixed income due to equity-market volatility and not understanding the impact of inflation, which reduces buying power. These two risks are closely related.

When interest rates rise (often because of increasing inflation), fixed income can lose significant value. We have experienced decreasing interest rates over the past decade that led to stable and often increasing bond prices. As interest rates increase, this trend will reverse; bond prices will decrease.

Inflation reduces buying power, which means a dollar tomorrow will not buy what a dollar today does. As people live longer and do more, it’s critical that their income keep up with inflation. The only way to do this is to own equity. Now, the hottest rate of inflation in four decades, which we just described, has ushered in a wilder era of bond-market volatility, which causes investors to shop for hedges to protect their portfolios.

Economists often measure market volatility using an index called the CBOE (Chicago Board Options Exchange) Volatility Index, called “the VIX.” It represents the market’s expectations for the relative strength of near-term price changes of the S&P 500 index (SPX). It generates a 30-day forward projection of volatility, or how fast prices change. It is an important index in the world of trading and investments because it provides a quantifiable measure of market risk and investors’ sentiments.

As with any index, there is vast fluctuation from one year to the next. For example, as of February 1, 2022, there was a 27.53 percent increase in the VIX. In 2020, there was a 65 percent increase, and in 2018 a 130 percent increase. In 2021, there was a 24 percent decrease in the VIX. In 2019, there was a 45.79 percent decrease, and in 2009, there was a 46 percent decrease.

We will guide you, as always, with prudent long-term planning

Although we can’t predict how many times the Fed may raise interest rates in 2022, the fact is that the amount of increase is more significant than the number of times. For example, three 50 basis point increases (a total of 1.5 percent) is greater than four 25 basis point increases (1 percent). A basis point is 1/100 of 1 percent of interest, or 0.01 percent.

We believe that, as inflation increases, the Fed will continue to signal about interest-rate increases and also increase rates. We could see a “shock and awe” increase, with the smaller increases following. If and when interest rates increase, the prices on long-term bonds will drop.

We believe investors should be cautious about long-term fixed-income holdings and be as intentional about fixed income investing as you are with equities. A properly allocated portfolio, and financial plan, should not depend on speculation. Our process takes into account the fact that we simply don’t know what we don’t know; therefore, we anticipate the unexpected, and we adjust to whatever happens with the Fed, the economy and the markets. We do expect inflation to continue to rise, along with interest rates.

A key to long-term success is taking a proactive approach to monitoring and updating planning and portfolio allocation. This does not mean trying to time markets;  rather it is accounting for economic, tax and personal changes.

We are here to help design, monitor and update your planning. Our team has more than 250 years of combined experience in all market conditions. As we enter a new period of higher inflation, higher interest rates and likely higher taxes, we are here for you. We are happy to answer questions and address any concerns. The current environment will present a good opportunity for those who are prepared to build long-term wealth. Conversely, those who do not have a disciplined and intentional approach may lose significant amounts. As always, your vision is our priority.

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Randy Carver, CRPC^®, CDFA^®, is the president and founder of Carver Financial Services, Inc., and is also a registered principal with Raymond James Financial Services, Inc. Randy has more than 32 years of experience in the financial services business. Carver Financial Services, Inc,. was established in 1990 and is one of the largest independent financial services offices in the country, managing $2.2 billion in assets for clients globally, as of December 2021. Randy and his team work with individuals who are in financial transition as a result of divorce, retirement or the sale of a business. You may reach Randy at randy.carver@raymondjames.com.

The information contained in this post does not purport to be a complete description of the securities, markets or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Randy Carver and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice.