The economic outlook appears to have some dark clouds forming on the horizon amid uncertainty about interest rates and inflation. After a few bruising months for stocks, many investors hope for the famed “Santa Claus Rally” to push stock markets up to close out the year. But with the S&P 500 down more than 12% below its all-time highs as of this writing, does it have a path to end the year in the green? To understand the market’s uncertainty regarding the Federal Reserve, we need to answer the question of “how do interest rates affect inflation?”
I’m not going to speculate on economic growth forecasts, forward-looking equity valuations, or anything of the like in this post. This is meant to examine the one remaining catalyst available to the market if it’s hoping to avoid the figurative lump of coal in the stocking this year.
If you’re firmly in this camp, you might not hope for a Santa Claus Rally, but instead for a Federal Reserve Rally. Jerome Powell, won’t you get this market out of the dog house and guide my sleigh tonight?
Hello Inflation, My Old Friend
Inflation is one bad dude. It erodes the value of your savings, makes things you buy more expensive, and eats into company’s earnings. The only people who love inflation are debtors.
For the past decade, inflation has been practically non-existent. It was even negative for a hot minute (also called deflation) during the Great Recession and the following years.
But recently, prices have begun to rise. And believe it or not, that’s actually a good thing. Increasing prices reflect a strong U.S. economy and an ultra-tight labor market.
When the economy heats up, companies must compete for workers and they do so by raising their compensation offers to potential new hires. They even need to raise pay for existing employees to keep them from jumping ship for a competitor. (Should you choose to leave, be sure to write a touching farewell letter to your colleagues before you depart!)
To offset these higher labor costs, firms can choose to raise prices, absorb the higher costs or use some combination of the two.
If the companies feel confident consumers will pay up for their goods and services, they opt for price increases, which preserves their profitability. When inflation rises for these reasons, it’s usually a good sign.
But what do good inflation readings really represent? Social and economic stability.
The Federal Reserve’s two primary jobs are to maintain a target inflation rate (widely seen as 2% per year) and help ensure maximum employment in the economy.
In a sense, as long as the public thinks everything will work out well, there’s a greater chance everything will work out well. Controlling expectations for inflation (and therefore inflation itself) will help to prevent mass hysteria like that seen during the Weimar Republic in Germany post World War I.
But what happens when economic growth starts getting hot and inflation rises too quickly? What can be done to combat this? Enter the Federal Reserve.
How Do Interest Rates Affect Inflation?
To understand how interest rates affect inflation, we need to look closer at the institution charged with taming inflation: The Federal Reserve. The Fed serves many roles in the economy, its primary one being monetary policy director. The central bank controls the money supply using interest rate policy (among other tools) and with it, how quickly the economy can expand.
Think of interest rates as the cost of renting money. As more people want to rent money using loans (increasing demand), the cost of money rises. Interest rates will only rise if the demand for money rises, which is what occurs when there is an acceleration in global economic activity.
The Fed can set overnight interest rates used by banks to loan to each other using the Target Federal Funds Rate. This rate could be considered the foundation of all interest rates because any changes made to this rate eventually pass through to business and consumer loans.
Many forms of debt set their interest rates based on this rate. One such example is the prime lending rate, which is the lowest rate at which non-banks (companies) can borrow money from commercial banks. This prime rate tracks the Target Federal Funds Rate.
For example, when loans are quoted to borrowers, they usually offer them based on terms like the prime rate + x basis points. To illustrate, if the prime rate is 3.00%, and the loan terms call for a prime rate + 250 basis points, the interest rate would be 5.50%. Each basis point equals 0.01%.
The Fed also has other tools available to it to control the money supply, such as bank reserve requirements, open market operations, and setting lending standards. But the one which gets the most press lately is certainly its control over the Target Federal Funds Rate.
This rate is why the Open Market Committee meetings are so important if you’re hoping for a potential “Federal Reserve Rally”. When the Fed thinks the economy is ramping up, it raises the Target Federal Funds Rate to fight inflation and reduce the demand for money.
Because we’re seeing some moderating economic activity based on recent data, it might cause the Fed to pursue a less aggressive rate increase path. If the Fed expects lower inflation (and thus slower economic activity), it might choose to reduce its expected number of rate increases in 2019. We now have an answer to the question of how do interest rates affect inflation, but what do markets think about the Fed’s decisions?
What Do Markets Think Will Happen with Interest Rates vs Inflation?
Currently, the bond market shows a 72% chance of the Fed raising rates today. Even with an increase today, there could still be a rally. The market has priced in the increase, but expectations for interest rate increases in 2019 is what is key.
The Federal Reserve Rally could be sparked by the Fed’s guidance about monetary policy in 2019, specifically if the Fed issues an easier tone about future rate increases. This would happen if the Fed sees cracks in the economic picture beginning to form.
While this might be good for the stock market in the short-term, it does present concerns for the economy going forward. Admitting there is less need to increase rates going forward forces the Fed to downgrade its economic growth forecasts.
However, the recent market volatility makes it hard to justify increasing rates at its original forecasted pace. History shows it’s extremely rare to raise rates when stocks have been beat up this much.
The Fed faces a tall task with its announcement today. It must exercise its independence to control rates based on (softening) economic data amidst a backdrop of falling stock prices.
If it chooses to hold off on rate increases, it admits defeat to not only the hectoring of the U.S. president but also to falling stock markets. These aren’t things the Fed usually has to consider when making their rate increase decisions.
A path forward where the Fed maintains independence and also “data dependence” would be to increase the Target Fed Funds Rate as expected but reduce the number of rate increases it expects to make in 2019. Doing so would walk a safer path.
This avoids raising rates too quickly and smothering economic activity when the Fed’s preferred inflation measure has abated recently. Currently, it falls below its 2% target and doesn’t seem to be as pressing of a concern as it was 6 months ago when the Fed announced its rate increase priorities.
The Larger Question Remains – What of Economic Growth and Inflation?
If slower economic growth is in fact occurring, the question then shifts from one about inflation to one about a darkening economic outlook. Will the market be able to brush off a less-vibrant economy in exchange for a slower rate increase schedule?
It’s become readily apparent that investors do not want hawkish rate increases going forward in light of lowered inflation readings. There might only be a handful of trading sessions left in the year, but depending on how the Fed announces its rate increase intentions, there could still be time for a “Santa Claus” turned “Federal Reserve Rally”.
Investors are increasingly expecting – and hoping for- more dovish (fewer rare increases) commentary from Fed Chairman Jerome Powell on the path for rates next year. Mr. Powell has given mixed signals on Fed policy in recent months, spooking investors in October by saying rates were “a long way from neutral,” referring to the point at which interest rates are neither spurring nor slowing economic growth.
In November, he backtracked on those comments by saying interest rates were “just below” neutral. Will the tone continue to soften in today’s announcement?
Related: Form W-2: What You Need to Know
Will Santa Have Enough Time?
As a final note, for those worried about time remaining to see the famed “Santa Claus Rally”, the traditional definition of this event is the last five trading sessions of December and the first two trading sessions of January. In that case, all eyes will be fixed on the announcement coming today at 2pm EST.
If it goes well, there’s still plenty of time left to rally to a positive finish for the S&P 500 in 2018. If we finish in the red, this will be the first year in the last 9 the S&P 500 hasn’t finished in the green.
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About the Author and Blog
In 2018, I was winding down a stint in investor relations and found myself newly equipped with a CPA, added insight on how investors behave in markets, and a load of free time. My job routinely required extended work hours, complex assignments, and tight deadlines. Seeking to maintain my momentum, I wanted to chase something ambitious.
I chose to start this financial independence blog as my next step, recognizing both the challenge and opportunity. I launched the site with encouragement from my wife as a means to lay out our financial independence journey to reach a Millennial retirement and connect with and help others who share the same goal.
Some of my favorite things to discuss include investing in index funds, how to save money, travel hacking with help from the Reddit churning community, house hacking and optimizing the benefits of my condo vs. apartment living, and tax topics like the earned income tax credit, common tax deductions, tax reform in 2018, or other useful tax topics. I want this to be a journey for us all to learn how to make a lot of money and pursue the lives we want.
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