Fed hikes interest rate – What does it mean for the economy and investors?

Fed begins the rate hiking cycle

The Federal Open Market Committee (FOMC) sets a target range for the federal funds rate, which acts as a reference for the interest rates of big commercial banks and it also influences interest rates throughout the global economy as a whole.

After two years of holding borrowing costs near zero since the beginning of the Covid pandemic, the Federal Reserve took the first step toward normalizing its policy during its March 2022 meeting to combat surging inflation. The Fed raised the target for the fed funds rate by 25bps to 0.25%-0.5%, in line with market expectations.

Revised inflation forecast ?????????

Inflation has been consistently running hot with the latest CPI reading for February reaching yet another 40 year high at 7.9% YoY. This was driven by higher headline inflation, given higher energy and food prices amid on-going Russia-Ukraine war, as well as by higher core inflation, as shelter and rent prices continued to climb higher.

Acknowledging that inflation will likely stay higher for longer, policymakers revised their forecasts higher. Inflation (core PCE) is expected to be at 4.1% this year, up from a 2.7% projection in December. For 2023, inflation is estimated at 2.6%, up from an earlier forecast of 2.3%. We expect inflation to start to moderate later this year as supply chain disruptions ease and commodity prices stabilize.

Aggressive path to future rate hikes

Despite geopolitical uncertainties, the Fed hiked its policy rate and hinted at a series of rate hikes to fight inflation. Given the large inflation revisions, the Fed now sees rate hikes at each of the six remaining meetings this year. The Fed expects seven hikes this year, four in 2023 and none for 2024, taking the policy rate to 1.9% this year and 2.8% by the end of 2023.

Fed’s Balance Sheet Reduction Plan

Currently, the Fed holds $9 trillion balance sheet, made up mainly of Treasuries and Mortgage backed securities it has purchased over the years. Policymakers expect to begin reducing its holdings and hinted that reduction could start in May and the process could be equivalent of another rate hike this year.

Impact on economy and GDP growth forecast

The U.S. consumer is in relatively good shape coming into the crisis, supported by healthy financial positions and excess savings of nearly $2.5 trillion versus where consumers stood before the pandemic. Strong employment is supporting income, savings are high, and household debt relative to income is low. All this suggests consumers are in the best financial position they have been in years.

High and rising commodity prices, fueled by the Ukraine crisis, is expected to reduce purchasing power, and will likely weigh on spending in the months ahead. However, the economy is still projected to grow at an above-average pace this year. Fed officials forecast 2022 GDP to grow 2.8%. This is lower than the estimate from just three months ago but still significantly above the last decade’s 2% average.

Equity Market Performance during previous rate hike period

US stocks have historically performed well during periods when the Fed raised rates, as a growing economy tends to support corporate profit growth and the stock market. In the past seven tightening cycles since 1977, S&P 500 has delivered an average absolute return of ~25.4% whereas Nasdaq delivered an average absolute return of ~42.9%. Even when we go more back in the past, stocks have risen at an average annualized rate of 9% during the 12 Fed rate hike cycles since the 1950s and delivered positive returns in 11 of those instances.

What should investors do?

The combination of still-robust but slowing growth and Fed rate hikes likely means higher volatility and lower returns. However, we expect the expansion to continue over the next two years, supporting equities while the market eventually transitions to the late-cycle stage.

We suggest investors view any Fed induced pullbacks as an opportunity to add quality investments as the robust consumer demand backdrop suggests revenue growth and corporate earnings to remain elevated this year as well, providing support to the equity market.

Furthermore, with the valuations having moderated due to the recent correction; it is a relatively good time for investors to accumulate positions in high conviction growth themes that will enjoy tailwinds from the structural changes in the way we live and work.

To get regular updates on international markets and global investing follow Cosmos Capital. Do subscribe to our newsletter and share this article with your family, friends and colleagues and help them to increase their financial quotient on international investing.