Was the Feds latest Interest Rate Move the Right Thing to Do? And Some Q & A

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First off, like many, I am fully convinced the Fed should have acted sooner – more like 4Q20/1Q21 versus mid-2022 – in raising interest rates and Quantitative Tightening (QT), or at least stopped the Quantitative Easing (QE). Had they done that, my speculation is that inflation would have stayed below 5% and we’d be well on our way back to 2% by now without a recession (soft landing).

However, I do believe the Fed is now on the right track (and hopefully will continue on its current path) to fix the problem. However, it could very well come in the form of a hard landing. At this point in time, I believe the question is how hard and for how long.

I’m basing this assessment on the inflation of the 1970s and the hard decisions/actions that Paul Volcker et al took in the early 80s, which is when Paul was the Federal Reserve Chairman (Jerome Powell’s current position). It led to a deep-but-brief double-dip recession and, most significantly, got inflation back in the box. As we know, inflation stayed in the box from the early 1980s, with only a couple minor flare-ups in 1990 and 2008, until 2021.

Fortunately, today’s inflation rate – as bad as it is – pales in comparison to the 13.6% inflation rate of 1980. So, hopefully, things won’t have to get as ugly this time in order to fix it.

Double caveat:

1) The government needs to stop printing money (QE or equivalent), as that only feeds inflation and undermines the Fed’s aforementioned interest rate hikes. This also translates to a significant reduction in deficit spending.

2) We need to get energy costs back in the box. The current situation looks encouraging regarding oil; however, we clearly have a significant unresolved natural gas cost issue. This means we need more production and more pipeline/transportation infrastructure.

Hence, IMO, if our elected and appointed government officials do these things in earnest, we’ll have inflation under control within a matter of a few months if not sooner. And the sooner we can achieve it, the less long-term damage inflation will cause and the sooner the Fed can lower interest rates and re-stimulate the economy.

Could the Fed be raising rates too much too quickly?

Some are concerned that the Fed isn’t giving prior interest rate increases enough time slow the economy (in a controlled way) and reduce inflation. There is no doubt that it takes some time for rate increases to ripple through the economic system and produce tangible results. However, the issue is really two-dimensional:

1) rate of periodic increases (e.g., 25, 50, 75 etc. basis points)

2) actual interest rate, which is almost always defined as the federal funds interest rate, which is the target rate at which commercial banks borrow and lend their excess reserves to each other overnight. It is set by the Fed (specifically the Federal Open Market Committee (FOMC), which is a branch of the Federal Reserve System (FRS)).

Note: The federal funds rate is different than the prime interest rate, which is the rate that banks typically lend to their most credit worthy customers, both corporations and individuals (e.g., mortgage interest, refinance rates, home equity loans, etc.). The two tend to correlate and move in tandem, but they are different. Much of the time, the prime interest rate is about 3% higher than the federal funds rate.

Like many other investors, I believe the federal funds rate was very low to begin with and is still in the range of easy monetary policy range, which is intended to stimulate the economy (like stepping on the gas pedal). Hence, it will take a series of large interest rate hikes just to get us into neutral territory (like taking our foot off the gas pedal). Depending how much a neutral fed funds rate will lower inflation (only time will tell), the Fed may have to hike rates even further into the restrictive monetary policy range (like stepping on the brake pedal) should inflation remain stubbornly high. I sincerely hope that is not the case, but I do believe the longer we let inflation run rampant, the more it will take to rein it in.

Thus, I do believe the Fed is acting appropriately by raising rates at an accelerated rate, at least until we’re well-penetrated into the neutral range (not easy nor restrictive). At that point, it MIGHT make sense to slow down the rate of increase, but only if inflation is well on its way down by then. The current anticipated scenario of one more 75-point rate hike in November followed by a 50-point hike in December seems about right, as that will put the federal funds rate at 4%-4.5%, which I believe would be at the high end (more toward restrictive) of the neutral range.

But wouldn’t it be bad if the rate hikes cause a recession?

As I have always said, a recession is definitely the lesser of the two evils when compared to inflation. Please keep in mind that recessions are actually part of a natural economic cycle, as they have an overall cleansing effect. I know a lot of people don’t like hearing this, but it’s true. Also, recessions tend to be relatively short-lived, and we recover from them.

By contrast, inflation is a thief, as we never recover from the high prices it produces. Except in a few highly-volatile areas like food and energy, those high prices are here to stay. Hence, time is of essence in our actions to stop the bleeding (i.e., erosion of our purchasing power), even if it means a recession.

IMO and as I stated earlier, had the Fed only acted sooner (early 2021), we probably could have achieved that coveted soft landing while preventing inflation to get so out-of-control. However, that’s clearly not the case today.

Since we are where we are today, and the Fed needs to base its actions on that. Again, it appears to me that they’re now on the right track. I just hope they have the guts to follow through, as there will likely be some political pressures to stop raising interest rates prematurely.

What should we do about today’s high energy costs?

Now that the Fed is moving forward with interest rate hikes and QT, I believe our primary focus should be on the aforementioned natural gas price problem, as it is driving electricity rates and heating costs for homes and businesses, thereby driving inflation – a lot! I’ll admit I’m a bit puzzled as to why this is such a problem and we’re simply letting it happen. Yes, we are exporting a portion of the natural gas we produce to Europe due to their sanctions on Russia, but we are also producing more natural gas due to our increased oil production and drilling/ production methods (e.g., horizontal drilling and shale production). IOW, we have a nice “bumper crop” of natural gas that’s a by-product and fringe benefit of our current oil production methodology.

However, sadly, oil/gas producers need to burn off much of this extra natural gas simply because we lack the pipelines and other infrastructure needed to transport it (my understanding). IMO, this is a direct and unintended consequence of environmentalists being overzealous in curtailing fossil fuel production too quickly. Please don’t get me wrong. I do believe we need to be good environmental stewards and incrementally replace fossil fuel energy with clean energy. However, that requires a methodical time-phased approach that balances meeting current demand for affordable energy with lessening our environmental footprint, not the current knee-jerk decisions and policies. Bottom line: We need to ensure clean, affordable, and reliable energy/related infrastructure is in place and available to the masses before we pull the plug on fossil fuels.

Meanwhile, regarding oil, the current ~$80/barrel price of oil seems about right, at least for now. If it goes too low, that would disincentivize oil companies from drilling, which would have the undesired backlash of less supply and higher prices going forward. Hence, I believe we should continue to monitor it and spot/mitigate upward price trends before they happen – or at least in their early stages – as we try to hold oil around $80/barrel.

How should I position my savings/investing strategy in today’s environment?

I am not a financial planner/advisor, but I am working closely with a very good one in managing my own retirement nest egg. Here are some things that I have learned over time and/or I have learned from working with my financial advisor:

Don’t panic and sell at a loss out of fear. It totally blew my mind how many smart people did this during the dot.com bust of 2000-2002 and the great recession of 2008-2009. Yes, it’s unnerving to see our portfolio values go down, but remember these are only paper losses and that our year-end 2021 valuations will very likely eventually recover (plus some). Hence, we must remind ourselves that such “losses” only become real when we sell at a loss.
Look at downturns as an opportunity to rebalance. Knowing what and how much to trade for what will likely require the expertise of a financial planner/investment advisor. However, in general, it’s likely best to sell what has increased the most/lost the least and buy what has lost the most. For example, it might be a good time to start investing some of that extra cash on the sidelines. Regarding the timing, again, I would recommend seeking the input of an investment advisor, as everybody’s situation is different. Personally, I’m a fan of dollar cost averaging, which is investing fixed $$ at fixed intervals. We end up paying less than the average price/share, as we automatically buy more shares when prices are low.
It might be a good time to convert some 401k and/or traditional IRA money into a Roth IRA. Just be careful to not let that bump you into a higher tax bracket!
If retired (like myself), it’s probably best to live off your cash, if sufficient funds exist, at least until the market recovers some. This is simply to avoid the “buy high, sell low” scenario that some retirees are forced into if they have insufficient cash.
If you are working and contributing to your retirement savings, and you are several years away from retirement, then I believe you have every reason to rejoice every day that your savings is dropping, because it also means you are buying stocks at bargain basement prices that we will likely never see again – ever. And remember, paper losses are just that, so long as we don’t sell.
Put some of your cash to work in CDs, bonds, etc. since today’s higher interest rates are starting to provide greater return rates for those invested in fixed-income assets. Again, talk to your financial advisor concerning how much to invest in what type of debt instruments.
Take a deep breath, and know that this too shall pass and that, in most cases, if you play your cards right, you’ll end up better off in the long run than you would have if the market had simply moved sideways.