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The appropriate gift for a one-year anniversary is said to be paper — something fragile that needs careful attention to be preserved over time.
The metaphor for a new marriage could equally apply to the current state of the economy, as last week marked one year since the Federal Reserve embarked on a series of hikes to short-term interest rates.
By this time last year, the Fed had kept its benchmark rate near zero since the beginning of the Covid-19 pandemic to help stimulate economic activity. But huge, pandemic-era injections of cash into the economy had caused rampant inflation.
So in March 2022, in an effort to slow the economy and cool inflation, the central bank raised rates by 25 basis points, bringing the target rate into a range of 0.25% to 0.50%. It was the first of eight hikes that have pushed the benchmark rate range to 4.50% to 4.75%.
The intended result has been achieved to an extent: inflation, as measured by the consumer price index, has shrunk to 6% from 8.5% a year ago. That still puts it a long way from the Fed’s target rate of 2%.
As the Fed mulls whether to continue upping rates, the central bank will have to consider the collateral damage rate hikes have brought to the economy, markets and investors.
“Monetary policy is a blunt tool,” says Ross Hamilton, a certified financial planner and vice president of wealth management at Raymond James & Associates in Bethesda, Maryland. “They’ve been feeling in the darkness for when things would break, and recently [with bank failures] things are starting to break. It muddies the picture of how they’ll proceed.”
The collateral damage of rate hikes for investors
The Fed’s task was always going to be a tricky balancing act. To ease inflation, the central bank needed to slow the economy. But slow things down too much or too quickly, and the economy could tip into recession.
For much of the past year, investors were skeptical the Fed could engineer a so-called soft landing — guiding inflation down without triggering a recession. Among other factors, fears of an economic slowdown led to a broad selloff in stocks in 2022, with the S&P 500 declining 18% on the year.
At the same time, because bond prices and interest rates move in opposite directions, the Fed’s hiking regime led to declines in the broad bond market. The 13% decline in the Bloomberg U.S. Aggregate Bond Index, together with the fall in stock prices, marked the first year that both stocks and bonds logged double-digit losses since 1969.
That spelled bad news for investors — specifically conservative retirement savers who held a mix of stocks and bonds. “There’s a general expectation that bonds are there to act as a ballast for stocks,” says Hamilton. “That didn’t occur last year. Investors got kind of a double-whammy.”
How rate hikes have affected consumers
High rates help slow the economy by making borrowing more expensive, which directly affects consumers. As of March 17, 2022, for instance, the average 30-year fixed-rate mortgage was 4.2% — higher than the mid-pandemic lows below 3%, but still a much better deal than the 6.6% you’ll pay on average today.
“Buyers are realizing that the days of 3% mortgages are over and that 6% is the new normal,” says J.R. Gondeck, managing partner at financial advisory The Lerner Group. “People have had to take a collective deep breath and reassess expectations.”
It’s gotten more expensive to hold a credit card balance, too. The average APR on a credit card is currently north of 19%, compared with a rate of 14.6% in February of last year, according to the Federal Reserve Bank of St. Louis.
In recent weeks, savers have felt the heat as well. Rising rates have eroded the value of many banks’ investments, including Treasurys, mortgage-backed securities and municipal bonds. When Silicon Valley Bank recently sold bond holdings at a loss, it triggered a bank run that led to the second-largest bank failure in U.S. history and brewing turmoil at regional banks nationwide, with consumers and investors alike wondering whether deposits are safe.
Where the Fed — and investors — go from here
Even with the recent signs of instability in the banking sector, the Fed looks poised to approve a quarter-percentage-point rate hike this week, according to Wall Street experts.
Given the Fed’s conflicting interests, where it goes from there is unclear. “The Fed has a tough goal. They don’t want to break things, but they also want to continue fighting inflation,” says Hamilton. “The waters are muddied and the consensus is all over the place.”
The Fed will continue to react to economic data, which could mean more hikes, a pause or even declining rates in the coming months. For investors, that likely means one thing: volatility. As investors look to get a grip on how the Fed will act, expect asset prices to jump around.
For long-term investors, this isn’t necessarily bad news, says Hamilton. “For folks starting out, early contributions they’re making now are going to make up a significant portion of their total account balance,” he says.
If you’re buying into a diversified portfolio at regular intervals, “you’re almost ideally set up to benefit from market volatility by buying at lower prices.”
If you’re stashing away money for a short-term goal, the good news about rising rates is that you can earn more money on low-risk instruments such as high-yield bank accounts and certificates of deposit.
“If you’re saving for a house and you’re getting 3%, 4% or 5% in cash or short-term bonds, that’s paying for a good chunk of closing costs with one year’s interest,” says Hamilton. In a choppy economy, “patience is ultimately key. Don’t get too discouraged.”
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