Fed

Quiz!

What are reasons for the Fed to lower interest rates? (There may be multiple correct answers.)

1. A decline in Inflation.
2. A mild recession in the US.
3. Core PCE Inflation reaches the 2% goal.
4. A slight increase in unemployment.
5. A severe recession in the US.
6. Very high unemployment.

What Moves Interest Rates?

For a long time, some experts predicted a decline in interest rates. How could they be so wrong for so long? What really drives the Fed’s decisions?

Topic	Expectation	Reality
What are normal interest rates?	Very low, after 0% for years	Closer to the current 5.5%
What inflation is needed?	Declining inflation	An absolute level of 2%
What is the target inflation?	Higher than 2%, maybe 3%	2%
How does inflation change?	Linearly	The decline typically slows down as it approaches 2%
How are employment & inflation balanced?	Employment isn’t a big factor. As long as inflation isn’t very high, we deserve low interest rates.	With unemployment so low, the main goal is to lower inflation
What are the Fed’s biases?	They want low interest rates	They don’t want to repeat the 1970’s where prematurely lowered rates let inflation spike again
What is good?	Low interest rates	Maximum employment with 2% inflation

Explanations: It seems that some people are driven by wishful thinking more than reality. Investors used the extremely low interest rates of the 2010s to justify extreme large US stock valuations, and they are eager to see interest rates go down. They hope to see very low interest rates as both the norm and the target. The Fed thinks very differently. They have two goals in mind (based on their job description): maximum employment and 2% inflation. With the employment goal in place, their focus is on getting inflation down. They saw inflation spike out of control in the 1970’s, and they are trying to avoid a repeat. The Fed said clearly that they will go as far as needed to reach their inflation goal.

What should we expect? Inflation is still nearly double its target: 3.5% vs. 2%. With inflation declines typically slowing down as we head towards the target 2%, we may have a long period with high interest rates. It is reasonable to expect the Fed to space out the rate increases further and further apart, as long as inflation keeps moderating. It may keep the interest rates the same for an extended period until inflation gets close to its target 2%.

Are there other scenarios? Yes. If the economy slows down and unemployment surges, the Fed will go back to a balancing act between employment and inflation, and could lower interest rates for a while. In that case, stock prices could do the opposite of mainstream expectations – they may decline. This could be most pronounced for stocks with the highest valuations (as measured by Price/Book).

Should we welcome lower interest rates? At first thought, lower interest rates are compelling, making it easier to fuel growth with cheap borrowing for companies & individuals. When considering the drivers of the Fed’s actions, lower interest rates without much lower inflation may be bad news – reflecting a response to a recession.

What can you do? You can structure your investments to benefit from high interest rates, and welcome the reality. Value stocks (with low price/book) tend to do unusually well with sustained high interest rates (not every month and not guaranteed). Note that your ideal investment allocation depends on your overall risk profile and goals.

Quiz Answer:

What are reasons for the Fed to lower interest rates? (There may be multiple correct answers.)

1. A decline in Inflation.
2. A mild recession in the US.
3. Core PCE Inflation reaches the 2% goal. [Correct Answer]
4. A slight increase in unemployment.
5. A severe recession in the US. [Correct Answer]
6. Very high unemployment. [Correct Answer]

Explanations:

1. The Fed seeks 2% inflation, not just a decline in inflation. Declines can moderate interest rate increases and space them out more, but less likely to lead to a reversal long before approaching the target 2%.
2. The Fed said repeatedly that it will accept a mild recession if needed to control inflation.
3. When Core PCE Inflation reaches its 2% goal, interest rates don’t need to stay elevated and would likely move down.
4. Slightly higher unemployment would still be low historically, and wouldn’t justify lower interest rates without much lower inflation.
5. A severe recession would likely lead to lower interest rates, though not guaranteed if inflation spikes very high.
6. Very high unemployment would likely lead to lower interest rates, especially if inflation isn’t very high.

Disclosures Including Backtested Performance Data