Federal Reserve focuses monetary policy on fighting inflation

The Federal Reserve (Fed) held the line on interest rates at the latest regularly scheduled meeting of the policy-making Federal Open Market Committee (FOMC), which concluded on November 1, 2023. The FOMC last hiked rates to a range of 5.25% to 5.50% in July, the highest fed funds target rate since 2001.¹

Fed chair Jerome Powell left open the possibility of more rate hikes. The FOMC will render its next interest rate decision in mid-December. Powell also made clear that the Fed will retain rates at current high levels for an indeterminate period of time. “The fact is the committee is not thinking about rate cuts right now at all,” said Powell.²

The Fed’s current rate policy represents a significant shift from its “easy money” stance that was in effect dating back to the financial crisis of 2008. Over much of that period, the fed funds rate was set to a range of 0.00% to 0.25%. In March 2022, as inflation surged, the Fed shifted course and rapidly raised rates throughout the remainder of 2022 and into 2023.

The Fed also reversed its previous policy of quantitative easing (QE), involving the purchase of Treasury and mortgage-backed securities to help boost capital market liquidity. The Fed’s balance sheet peaked at nearly $9 trillion in April 2022.³ Now, a so-called “quantitative tightening” approach has reduced the Fed’s participation in the bond market. Its balance sheet declined to roughly $7.9 trillion near the end of October 2023, down 11.8% from its peak,3 but still sizable by historical standards.

A reaction to inflation

The Fed’s primary focus it to temper the rapid rise in the cost of living. Headline inflation, as measured by the Consumer Price Index (CPI), peaked at 9.1% for the 12-month period ending in June 2022, then dropped significantly. CPI stood at 3.7% for the 12-month period ending in September 2023.⁴ “The Fed emphasizes that 2% is its annual inflation target,” says Eric Freedman, chief investment officer, U.S. Bank Wealth Management. “Despite its progress over the last two years, current inflation is still a far cry from the Fed’s target rate.” Powell agrees. “A few months of good data are only the beginning of what it will take to build confidence that inflation is moving down sustainably toward our goal,” noted Powell.⁵

Despite significant Fed monetary tightening, the U.S. economy is proving resilient. The initial estimate of third quarter 2023 Gross Domestic Product (GDP) data showed a 4.9% annualized economic growth rate.⁶ In his recent comments, Powell stated, “Evidence of (economic) growth persistently above potential, or (signs) that tightness in the labor market is no longer easing, could put further progress on inflation at risk and could warrant further tightening of monetary policy.” Freedman also notes, “With Americans earning consistently higher wages, the Fed also upgraded its growth projections for 2024.” That’s an important change, says Freedman, because along with the risk that the Fed could bump rates higher, the data tempers expectations around interest rate cuts by the Fed next year.

Role of the Fed

While the Federal Reserve acts as the U.S. central bank, maintaining an effective payment system and overseeing bank operations, investors primarily focus on the Fed’s monetary policies. Congress’ mandate for the Fed is to maintain price stability (manage inflation); promote maximum sustainable employment (low unemployment); and provide for moderate, long-term interest rates.

Fed monetary policy influences the cost of many forms of consumer debt such as mortgages, credit cards and automobile loans. While Chair Powell receives much of the attention, the FOMC establishes Fed monetary policy. It’s the committee that sets the fed funds target rate and has other authority, including buying and selling of securities.

Rate hikes near an end, but high rates persist

Another Fed rate hike is possible, but the markets are increasingly focused on when the Fed will begin to lower rates. “The Fed needs to be convinced that it is on top of any risk of inflation’s resurgence,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “One challenge is that the Fed may temper demand as a way to ease pricing pressures, but it can’t really affect supply issues that arise.” Haworth points out that ongoing shortages of labor that keep wages elevated represent a supply issue that’s mostly out of the Fed’s control.

Bond market responds

The interest rate environment across the broader bond market underwent dramatic change since early 2022, with yields rising across the board. In an unusual occurrence, yields on shorter-term Treasury securities are higher than those on 10-year and 30-year bonds. At the end of October 2023, the yield on 3-month Treasury bills stood at 5.59% compared to 5.07% on 2-year Treasury notes and 4.88% on 10-year Treasury notes.⁷ This inverted yield curve dynamic contrasts with normal circumstances, when investors demand higher yields for bonds with longer maturities.

Source: U.S. Department of the Treasury, Daily Par Yield Curve Rates.

Will the investment environment change?

As the Federal Reserve approaches what could be the peak in its current interest rate-hiking cycle, what does it mean for investors? Freedman says tighter monetary policy is equivalent to steepening the ramp on a treadmill. “The Fed is producing more economic resistance, which will likely slow the level of economic growth,” according to Freedman. What’s not clear is the full effect the Fed’s actions will have on the economy or markets.

However, today’s market appears to offer opportunities for investors to return to more neutral portfolio positioning. Here are potential moves that may be appropriate for a diversified portfolio given the current environment:

• Fixed income market. Today’s higher interest rates make fixed income securities more attractive. While higher yields can be earned in short-term debt instruments, it’s important to also consider longer-maturity U.S. Treasuries as well to help support portfolio diversification. Tax-aware investors may want to consider a modest allocation to high yield municipal bonds. Within certain non-taxable portfolios, consider a meaningful investment in non-government agency residential mortgage-backed securities. Trust portfolios may consider reinsurance to capture attractive income with low correlation to other portfolio components.
• Equity markets. Equities seem more attractively positioned than has been the case recently, but Haworth says investors should be prepared for choppiness in the markets. “Investors who have assets to deploy in the stock market may wish to consider dollar-cost averaging over a period of time (consistently investing over at least a six-month period).” This systematic investment approach has the potential to mitigate risks during volatile market periods, while still allowing investors to put money to work in equities to meet long-term goals.

Be sure to consult with your financial professional to review the positioning of your portfolio to determine if changes might be appropriate given your goals, time horizon and feelings toward risk given today’s higher interest rate environment.