Is it time to raise rates?

As we discussed a few weeks ago, newly appointed Federal Reserve Chairman Kevin Warsh, has a challenge on his hands. Inflation is still running above the Federal Reserve’s 2% target.  More concerning, it has begun to move in the wrong direction, rising from a 2026 low of 2.4% in January and February to a concerning 4.2% in May and 3.5% in June as measured by Consumer Price Inflation (“CPI”).  Admittedly, much of the rise in inflation over the past few months relates to the spike in oil prices due to the Iran war, but even core CPI, which excludes volatile food and energy costs, rose 2.9% in May and 2.6% in June. These numbers are putting increasing pressure on the Federal Reserve to raise interest rates to fight inflation. The July release of CPI is scheduled for August 12. If inflation remains above the 2% target once again, the Federal Reserve may be forced to raise interest rates at the September Federal Reserve meeting.

Given that we are facing another cycle where the Federal Reserve is raising rates, it is worth reviewing the implications of such a move. The general principle is that the Federal Reserve raises interest rates in an effort to slow the economy and reduce inflation. Higher interest rates are also generally considered a headwind for stocks.

However, there is broad misperception that the Federal Reserve sets interest rates for things like company loans, mortgages, car loans and even credit cards, which is not the case. The Feds impact on interest rates in the broader economy is indirect. In fact, even though the Fed has an enormous effect on rates, the market ultimately is the guide to what companies and individuals are charged for loans.

There are many other factors that determine overall interest rates, especially interest rates for long term loans like mortgages. Remember that the Federal Funds Rate is an overnight rate and is quite different from a 30-year mortgage.  Therefore, the change the Fed is making is likely to impact short term loans more directly. In the long-term other factors such as inflation expectations, economic growth, and demand for borrowing can be more important than the Federal Funds Rate.

Be wary of people that forecast rising interest rates due to the Federal Reserve raising the Fed Funds rate. In this environment, long-term interest rates could actually fall if the Federal Reserve shows its commitment to lowering inflation by raising the Fed Funds rate.