U.S. Federal Reserve and Interest Rate Developments

On April 21, Federal Reserve Chairman Jerome Powell cited the clearest indication of support for a significant increase in the Federal Reserve’s (“the Fed’s”) benchmark interest rate. Additionally, as the capital markets and investors digest the below observations, investors should review their aggregate portfolio construction and asset class allocation, risk tolerance, targeted portfolio returns, and tax considerations—including unrealized portfolio gains and losses, investment time horizon, and additional factors—unique to them.

Federal Reserve Activity to Lower and Manage Inflation

The Fed’s Board of Governors is reviewing and determining discount rates to be charged by the Federal Reserve Banks. However, Chairman Powell’s April 21 comments cited a likely Fed increase of 0.5%, the primary reason being to lower and manage inflation.

The Fed’s federal discount rate and the federal funds rate (the rate of interest that banks use to lend money to each other) are used to control the supply of available funds and other reliant interest rates. Raising the discount rate makes it more expensive to borrow, thus lowering the supply of available money, which then increases the short-term interest rates and helps keep inflation in check.

In February 2020, the federal funds rate was 1.58% compared to 0.13% in February 2010. In July 1954, the rate was under 1% and reached a historic high of nearly 20% in 1980 and 1981. This peak was a result of efforts to counter inflation, which resulted from President Nixon removing the U.S. from the gold standard in 1971.

Mortgage Rates Are Rising

On April 21, the Federal Home Loan Mortgage Corporation (“Freddie Mac”) cited the average interest rate for a 30-year fixed rate mortgage rose to 5.11%; this rate was 3.22% at the start of 2022.

As interest rates rise, the cost of borrowing money becomes more expensive. This causes purchasing goods and services to be more expensive for consumers and businesses. For example, as cited above, purchasing a home becomes more expensive as mortgage rates have risen. Financing growth for a business also becomes more expensive as loan rates increase. When this happens, consumers spend less, which results in a slowdown of the economy.

The Impact of Interest Rates on Inflation

In general, rising interest rates spur inflation, while declining interest rates slow inflation. When interest rates decline, consumers historically spend more, as the cost of goods and services is cheaper because financing is less expensive. Increased consumer spending means an increase in demand, and increases in demand increase prices, which can generally lead to inflation. Conversely, when interest rates rise, consumer spending and demand decline, and prices and inflation follow.

Interest Rates and the Equity Markets

On April 22, the Dow lost roughly 600 points in afternoon trading while the S&P 500 and the Nasdaq declined 1.8% and 1.7%, respectively. Investors responded to both the remarks from Chairman Powell and corporate earnings results; generally, the major equity indices decreased 2%.                                                                                            

There was another rally in 10-year Treasury yields, which, in turn, caused investors to turn away from the high-growth technology sector. U.S. stock indexes are now on track to likely post a decline for the week ended April 22. Generally, rising interest rates hinder the performance of stocks. As interest rates rise, individuals see a higher return on their savings. This removes the need for individuals to take on added risk by investing in stocks, resulting in less demand for stocks.