The Fed Signals Higher Interest Rates Won’t End Until Runaway Inflation Does
Sept. 30, 2022 |
The C2FO Team
For the third meeting in a row, the US benchmark rate climbs by 75 basis points.
Inflation remains stubbornly high, so the US Federal Reserve is doing exactly what it said it would.
On Sept. 21, the Fed raised the federal funds rate by another 75 basis points — the third meeting in a row where policymakers increased it by that amount. The rate will rise to 3% to 3.25%.
And the Fed isn’t done yet. Officials say the federal funds rate could hit 4.25% to 4.5% by the end of 2022 as the Fed has two more meetings scheduled for this year, which effectively locks in another 75 bps raise and a 50-75 bps raise.
“My colleagues and I are strongly committed to bringing inflation back down to our 2% goal,” Fed Chairman Jerome Powell said in a news conference. “We have both the tools we need and the resolve that it will take to restore price stability on behalf of American families and businesses.”
Translated, Powell is indicating that the Fed is now 100% focused on inflation, which is different from its normal focus on inflation and employment. And the mentioning of “resolve” is a throwback to the thinking of former Fed chair Paul Volcker, who famously broke the back of runaway inflation in the 1980s.
The Fed wasn’t alone in raising rates in September. Several central banks — including those in the UK, Indonesia, Norway, Switzerland and the Philippines — instituted their own larger-than-usual hikes around the same date.
The Fed's rate hike was a reminder that, until inflation truly declines, interest rates will stay high.
When inflation dipped in July, there was hope that further increases might be milder. Unfortunately, August’s inflation numbers — though down year over year — were up from the previous month.
For the last few months, Powell and the Fed have been trying to get the message across through rhetoric, and the message hadn’t landed yet, said Chris Atkins, C2FO’s president of capital finance and capital markets.
With this latest hike and the corresponding equities selloff, it might finally be sinking in for folks that higher interest rates are going to be sticking around.
How the Fed’s interest rate hikes help fight inflation
Raising the federal funds rate makes borrowing more expensive for everyone, whether you’re using a credit card or buying a new home. Here are the mechanics of how it’s supposed to work:
The federal funds rate is the interest rate that banks charge each other for borrowing funds overnight.
But it’s also used by many banks and institutions to set the prime rate, aka the interest rate that banks and credit unions charge their best, most creditworthy customers. The prime rate is usually about 3% higher than the federal funds rate.
The prime rate serves as a benchmark for all kinds of financial products, from mortgages to credit cards to business loans.
If borrowing becomes more expensive, it means more people won’t be able to afford loans for cars, houses, business expansions, etc. That reduces demand, which — in theory — will help lower prices.
The Fed’s dual mandate of keeping inflation in check and supporting full employment are thereby naturally opposed and are tough to keep in full balance.
The (kind of) good news is there have been signs that parts of the economy are slowing as a result of higher interest rates.
For example, existing-home sales have declined for the seventh month in a row and, in August, were down 19.9% compared to a year earlier, the National Association of Realtors reported. (Prices, however, were up 7.7% year over year.)
As a result, appliance and furniture sales — which are often driven by home purchases — are down, too.
Unfortunately, overall consumer spending was still high in August, including categories like food, clothing and sporting goods, and there’s been little change in the extremely hot job market.
“Despite the slowdown in growth,” Powell said, “the labor market has remained extremely tight, with the unemployment rate near a 50-year low, job vacancies near historical highs and wage growth elevated.”
The Fed is particularly concerned about the job market because it wants to prevent a wage growth spiral.
That’s when demand for workers is so great that employers keep raising wages — and increase the cost of their goods and services to cover the higher pay. Which in turn causes workers to push for higher wages, and on and on, driving inflation higher and higher.
The Fed predicts higher interest rates will be with us for a while
As part of September’s meeting, the Fed also released the latest economic predictions from its members. They forecast that:
The federal funds rate should stay above 4% next year and hit 4.6% by the end of 2023. Rates should sink back to 2.9% by late 2025, though that’s still above the Fed’s ideal rate of 2%.
Gross domestic product will be 0.2% for this year and 1.2% next year, well under the normal growth rate.
Unemployment will hit 4.4% by the end of 2023. Unemployment was 3.7% in August.
Powell said the Fed will be keeping a close eye on inflation over the coming months. If price increases start to moderate, that will affect the pace of interest rate hikes.
What businesses should do now
Businesses should prepare for two facts, Atkins said:
Recession is practically assured for Europe, the US is highly susceptible to one, and China’s growth rate will remain slow. Global recession is likely depending on (a) consumers and (b) how the Russia-Ukraine war continues to unfold.
The days of cheap capital are over, at least for the time being.
Borrowing is going to cost more, so businesses need to do what they can to increase their cash flow and profits to ward off these increased costs.
“You’ve got to control what you can control so you can be ready for what you can’t control,” Atkins said.
Early payment programs like C2FO’s — where suppliers offer a small discount in exchange for faster payment of invoices — can accelerate your cash flow and give you better access to funds. The cost of the discount is almost always cheaper than the cost of borrowing from a lender, and it increases your ability to use cash flow to not only fund operations, but growth, too.
Whatever your goals, having access to capital can help you navigate whatever the economy does in the next few years.
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