Inflation is more of a concern than rising interest rates | Opinion

On December 15, the Federal Open Market Committee of the Federal Reserve made a significant change in monetary policy in response to rising inflation.

The Committee accelerated the reduction of its bond-buying program to tighten the money supply and forecast three hikes in the benchmark federal funds rate in 2022. Both measures were more aggressive than previous FOMC actions or projections. . To understand how these steps could affect the US economy and your investment portfolio, it may be helpful to take a closer look at the tools and strategy of the FOMC.

As the nation’s central bank, the Federal Reserve operates under a dual mandate to promote price stability and maximum sustainable employment. This is a balancing act, as an economy without inflation is usually stagnant with a low employment climate, while a booming economy with lots of jobs is susceptible to high inflation.

The FOMC, which is responsible for setting monetary policy under the Fed’s mandate, has set an annual inflation target of 2% based on the personal consumption expenditure price index. The PCE index represents a wide range of spending on goods and services and tends to lag behind the most widely circulated consumer price index. The Committee’s policy is to allow PCE inflation to operate moderately above 2% for some time to balance out periods when it is below 2%.

PCE inflation was generally well below the Fed’s 2% target from May 2012 to February 2021. But it has been rising rapidly since then, hitting 5.7% for the 12 months ending November 2021. ( By comparison, CPI inflation was 6.8%). Fed officials originally thought the inflation was “transitional” due to supply chain issues related to the opening of the economy. But the persistence and level of inflation over the past few months have led them to take corrective measures. They still believe inflation will come down significantly in 2022 as supply chain issues are resolved, and project a PCE inflation rate of 2.6% by the end of the year.

The FOMC uses two main tools in its efforts to achieve the appropriate balance between employment and prices. The first is its power to set the federal funds rate, the interest rate that big banks use to lend money to each other overnight to maintain required deposits with the Federal Reserve. This rate serves as a benchmark for many other rates, including the prime rate that commercial banks charge their best customers. The prime rate serves as a benchmark for consumer loan rates such as credit cards and auto loans. The FOMC lowers the funds rate to stimulate the economy to create jobs and raises it to slow the economy to fight inflation.

The Fed’s second tool is to buy Treasury bills to increase the money supply or to allow bonds to mature without buying them back to reduce the money supply. The FOMC buys Treasury bills through banks within the Federal Reserve System. This provides the bank with more money to lend to consumers, businesses, or the government (by buying more treasury bills).

When the economy shut down in March 2020 in response to the COVID pandemic, the FOMC took extraordinary stimulus measures to avoid a deep recession. The Committee cut the federal funds rate to its lowest range of 0% to 0.25% and launched a bond-buying program that reached an all-time high of $75 billion a day in bonds. of the Treasury.

In June 2020, this amount was reduced to $80 billion per month and remained at this level until November 2021, when the FOMC decided to end the program at a rate that would have ended it by June. 2022.

The December decision accelerated the slowdown, so the bond-buying program will end in March 2022, when the FOMC will likely consider raising the federal funds rate. While it is uncertain when an increase will occur, the December projection is that the rate will be between 0.75% and 1.00% by the end of 2022 and between 1.50% and 1.00% by the end of 2022. 75% by the end of 2023.

The Fed’s current plan aims to slow inflation by returning to a more neutral monetary policy; it represents confidence that the economy is strong enough to grow without extreme stimulus. If these are the only actions required, the impact may be relatively mild. And the first rate hike will probably only come in the spring.

Still, rising interest rates are making borrowing more expensive, which could impact corporate profits and consumer spending. And rates have an inverse relationship with bond prices. As interest rates rise, the prices of existing bonds fall (and vice versa), because investors can buy new bonds by paying higher interest. On the other hand, higher rates on fixed income securities could help investors, especially retirees, who rely on fixed income investments.

As 2022 begins, inflation is a far bigger concern than rising interest rates, and it remains to be seen whether the Fed’s planned rate hikes will be enough to bring prices under control. For now, it may be best not to overreact to the change in policy and maintain an investment portfolio suited to your long-term goals.

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