Federal Reserve Raised Short Term Interest Rates

The Federal Reserve has raised short term interest rates by 50 basis points.  This is the first time in two decades that the Fed did a 50 basis point move upward.  The hope is that inflation is held at bay.  But, in a statement released by Federal Reserve Chairman Jerome Powell, he said that the Fed had not been considering a bigger increase in interest rates; he believed inflation would be contained.  And, with that, the stock market breathed a collective sigh of relief… and rallied some 1,000 points in one day.

I am going to break down what inflation looks like right now.  And, I am going to break down how a 50 basis point move looks for the future.  I will show that inflation is likely to be contained and that despite there being higher interest rates coming soon, the economy is quite strong and will move forward.

Inflation

In case you have not heard, or noticed, prices are a lot higher today than they were one year ago.  The actual statistics?  Prices have increased on average by approximately 6.5% Year-Over-Year^[1]The PCE Deflator is the Federal Reserve’s favorite inflation Indicator.

Personal Incomes Rise Sharply

The breakdown of how inflation got so high is actually simple to follow once you see where it originated.  First, a little more than a year ago, the federal government issued three rounds of Economic Impact Payments.^[2]Economic Impact Payments Considering that many Americans still retained their jobs – but, worked from home – these payments sent personal incomes up considerably.

There is a direct correlation between personal incomes and personal expenditures.  Mostly, as Americans earn more and more, or less and less, on a year-over-year basis, the rate of change is reflected in the rate of change in expenditures.  The correlation between the rate of growth of incomes & expenditures is nearly 1, either positive or negative.

It is important to note that in the United States, some 50% of all Americans have zero dollars in their savings account.  And, only about 25% have approximately $1,000.00 in savings.  Because of the tenuous constraints on US consumers, any fluctuations in a vast majority of Americans’ incomes will directly affect their expenditures.

So, if you wanted to know the future outlook of the US Economy, and because the US Economy is mostly 70% consumer-driven, analyzing the growth rates of incomes will tell you what will happen next in expenditures and the overall US Economy.

Personal Expenditures rise sharply

There was an initial decline in the rate of growth of expenditures because of nearly 15% of Americans were suddenly unemployed during the initial onset of the pandemic and ensuing lockdown of life.  You can see the big shift lower on a year-over-year basis in the early part of 2020.  Then, the US Federal Government sprang into action with the Economic Impact Payments to help families in distress over their financial situations.

After the Economic Impact Payments were processed, Americans shopped and spent a lot of those funds on goods & services.

But, the supply chain was broken.  So, after Americans acquired their goods, businesses then sought to restock their supplies.  But, the supply chain was greatly affected by the pandemic and its requisite shutdown in many parts of the world.  Without raw materials in ample supply, as well as worker shortages being able to produce products, prices rose sharply.

The Economy & Short Term Interest Rates

The Federal Reserve has raised the overnight target rate upward by 50 basis points. In the big picture, this is not a significant move.  But, it does signify some important things.  One of the most important aspects is that the target rate moved upward by 50 basis points at one time.  This is the first 50-point basis move upward in 2 decades.

This signifies that the Federal Reserve is going to move the target rate upward more over the course of the next couple of years.  Looking at the chart above, despite the dramatic incremental rise, by perspective, the short-term overnight target rate is still very low historically.

Also, the target rate is now only approximately 0.75% – 1.00%.  The highs were set in the 1980s when short-term interest rates were ~20.00%.

What is the Overnight Target Rate?

The Overnight Target Rate is exactly what it sounds like, the rate at which the Federal Reserve lends money to its member banks should they need to borrow from the Federal Reserve, the lender of last resort.

The Overnight Rate is a target and is not set but, mandated.  The New York Federal Reserve Bank is responsible for maintaining the target rate.  This is the rate at which the Federal Reserve would lend to any bank should they need short-term liquidity.  The target rate is the starting point for short-term interest rates.  Banks would lend to other banks at a rate slightly above the Fed Funds rate.

There are 12 Member Banks within the Federal Reserve System^[4]The Federal Reserve System.  And, banks that want to communicate with the Federal Reserve operate within the 12 regional areas of the Federal Reserve. Should any bank need to borrow funds to shore up its reserve requirements, it would borrow funds to maintain its reserve requirement levels.  Banks are encouraged to borrow from one another.  However, if no bank were able to borrow from any other bank, then that bank could borrow from the Federal Reserve.

By targeting a specif level, and the fact that banks would charge interest higher than what the Federal Reserve targets, this has the effect of raising interest rates throughout the entire economy.

How Short Term Interest Rates Affect the Economy

This is probably the most important part of this breakdown for the Federal Reserve’s latest increase in the overnight rate: How does this affect the economy?

As noted above, with the increase in the Federal Reserve overnight rate, banks will increase their own interest rate levels.  So, any bank that wants to borrow from another bank will have to do so at a higher interest rate than just before this announcement.

This will create ripple effects throughout the economy.  Interest rates for nearly everything will start to rise since the short-term interest rate level just moved higher.

For instance, interest rates for auto loans, credit cards, and mortgages will all move higher.  Given that, and when you consider the US Savings rate with 50% of the country having zero savings, this will greatly impact the overall economy.  Individuals that have payments going toward credit cards are now going to have to pay more toward their credit cards.

This has the effect of “taxing” the economy.  If an individual has a static income, and they are spending 100% of that income every month, and all of a sudden one of the expenses that they have already been paying money toward goes higher, that person will not be able to spend money on another item of interest because of this increased payment.

Expenditures will trend downward

When you consider that incomes are not trending higher at the same rate, inflation is higher by a factor of 6.5%, and the fact that 75% of the country is effectively living paycheck-to-paycheck, with these “taxes” on the consumer, expenditures will start to trend downward.

The US consumer is seeing an overall increase in prices at grocery stores and the gas pump.  Now, the US consumer is going to see higher increases in credit card payments for items they have already acquired and are still paying for.

These additional costs will mean less could be consumed.  This will have the effect of slowing the economy on a rate of change, if not push the economy lower into negative growth territory.  It should be noted that GDP was reported negatively over the past quarter.  This was driven because of the increase in inflation with flat income growth rate.

With higher interest rates, this will mean a slightly more decrease in expenditures.

Autos & Homes will be more expensive

Another effect of higher interest rates will be that auto prices, already being driven higher because of inventory shortages, will see payments increase for anyone getting a new loan.  As interest rate increases move higher, interest payments will increase.  So, anyone financing a new or used vehicle will have to pay more now – and, even more in the future as interest rates continue to increase – than they would have to pay just yesterday.

Mortgage payments are also going to move higher with increased interest rates now and more so in the future.  Anyone with a fixed income but wanting a mortgage will see the payment for the very same house to increase.  This may have the effect of slowing home price increases as it has the ability to dampen demand.

The Current Yield Curve

The Yield Curve is a combination of all US Treasure Yields^[5]US Treasury Yield Curve displayed linearly. This is a graphic representation of what current US Treasury yields are at any given moment.  Above, you can see three different lines.

The red line indicates where the yield curve was at the very bottom of the pandemic when the Federal Reserve moved to create tremendous liquidity within the system to sustain economic activity.

And, the grey line was at the height of economic activity just before the global pandemic and its ensuing lockdown and economic malaise.

Finally, the black line indicates the most recent yield curve.  This shows that interest rates, on a comparative basis, are well below normal for continuous economic activity.  Increases in the Federal Reserve overnight target rate will continually “inflate” the yield curve to a more normal level.

I follow the yield curve religiously as I am both an options trader and the broader stock market trader.  I looked at the inverted yield curve just recently and thought the moves in the stock market driven by this were unwarranted.

Stock Market & Short Term Interest Rates

Initially, the stock market rallied on the news. But, subsequent events are bringing the stock market right back down.

Normally, the stock market would have digested the news in stride with interest rates heading higher.  But, there has been a souring of sentiment since the initial news release.

Economic indicators out of China show that manufacturing numbers are slowing aggressively. If companies cannot get supplies out of China, this will have many knock-on effects that will ripple through the economy (Fewer supplies from shortages mean higher prices).  And, the war in Ukraine is dragging on sentiment.

Look for more sideways movements driven by the increase in interest rates.  Over the next year, we are likely to continue seeing interest rates increase by 50 basis points.  The market will start to digest the idea that we will be seeing some 200 basis points increase in short term interest rates over the remainder of the year.  And, as you can see from the interest rate level, this is far from dramatic.