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Why Rising Interest Rates Matter

Why Rising Interest Rates Matter

September 23, 2022

Where We Are Now

Rising interest rates mater as taming inflation continues to be the Fed’s main objective. With the annual core inflation reading for the 12-months ending August 2022 at 6.43%, inflation is far from the Fed’s stated goal of 2%. Raising interest rates is a monetary policy tool that central banks rely on to reduce money supply and slow inflation growth.

At Wednesday’s FOMC meeting, the Fed decided to increase interest rates by 75 bp for the third time this year. More important than any single rate hike are terminal rate expectations, which is the level we expect the Federal Funds rate to reach during the current tightening cycle. Following this week’s meeting, median terminal Fed expectations for 2023 have increased from 4.25% to 4.625%.

Why Should We Care About Rising Interest Rates?

Interest rate increases have led to lower expectations of future earnings growth for US companies. Investors may be reluctant to buy equities because future earnings will look less appealing and they can find other investment vehicles with increasingly attractive yields. Fed Chair Powell’s warning on economic pain during Wednesday’s meeting has also stoked recession fears, with Powell specifically calling out the housing market saying it will likely go through a “correction.” GDP forecasts have been cut and unemployment is expected to increase in the near-term.

Optimism For The Future

Central banks around the world are taking their cure from the Fed. The result is coordinated policy tightening, which will likely lead to a faster deceleration in inflation than if the US were acting along. Other events that could prompt slowing inflation include resolution of the Russia/Ukraine war and China reopening its economy to the world. The 300 bp rate increase the Fed has delivered over the last 18 months is the largest increase in such a short span since 1980. However with today’s debt/GDP ratio roughly double that of 1980, we would expect Fed rate increases to produce their desired effect more rapidly.