Good morning & happy Monday!
The real key to making money in stocks is not to get scared out of them.
Peter Lynch
As I promised last week, today I will talk about the Fed (I can tell you are excited 😉). It is the Fed that is causing the majority of the heartburn in the market these days.
The Fed refers to the Federal Reserve which consists of 7 members (known as governors) with the chairman being Jerome Powell.
The Fed has 2 main jobs (known as their ‘dual mandate’):
- Low & stable inflation
- Maximize the number of people employed in the U.S. (full employment)
Obviously, inflation has been a major issue for our nation and the entire world. It is a complicated issue that I addressed a bit in last week’s memo.
Since it’s the Fed’s job to manage inflation, they have financial tools at their disposal to accomplish this objective. Their primary tool is adjusting the fed funds rate. This is the rate in which they lend money to banks, and in turn, what rate the banks lend money to their customers.
Let’s look at a couple of examples and then tie together with what’s going on in the market right now.
At the beginning of this year the prime lending rate (which the Federal Reserve sets) was 3.25% (United States Prime Rate History (fedprimerate.com))
and the average 30-year mortgage rate was 3.11% (30 Year Mortgage Rate (ycharts.com)) Currently the prime lending rate is 6.25% and a Google search shows the average 30-year mortgage rate is hanging around 7.50%.
Let’s look at how these rate changes actually affect real life:
10 months ago, if I got a $500,000 mortgage at 3.11% my monthly payment would be $2,138/month (not including taxes & insurance)
Today at a 7.50% rate a $500,000 mortgage monthly payment would be $3,496 (not including taxes & insurance)
That’s a 63% increase in my monthly payment! In this example that’s $1,358 more I am spending on interest.
That dramatic increase in interest rates leads to a dramatic increase in the cost of a mortgage … and car payments, and credit cards, and equity lines of credit, and virtually every other type of loan out there.
This means I now would have to spend a lot more of my money on interest and that means I have less money to spend elsewhere … which is exactly what the Federal Reserve wants! When I have less money to spend that means I am buying less stuff and that lowers the demand side of the supply-demand equation. Lower demand leads to lower prices.
If I own a hotel and it was packed a year ago my occupancy is probably lower now because less people are traveling because more of their income is going to loan interest payments (higher mortgages, higher car payments, etc.). So, in order for me to fill up my hotel rooms I will have to charge lower prices to try to attract more customers. This lowering of prices happens across the board, in all sorts of industries, and eventually should lead to reduced inflation as business will have to lower the prices they charge their customers.
This is why we are seeing a reduction in home values … people can’t afford the same house they could have afforded earlier this year because the payment will be so much higher. Lower demand = lower prices = less inflation.
When the Fed wants to slow the economy down (and thus lower inflation) they will raise the interest rates. Higher rates = lower demand = slower growth = less inflation. That is what they are doing now.
The opposite is also true … when the Fed wants to stimulate the economy (like they did during the pandemic) they will lower the interest rate. That means people are spending less money on loan interest and will have more money to spend in the economy … which will increase demand on the supply-demand equation. Lower rates = higher demand = more growth = greater inflation.
During Covid, inflation was super low and not an issue so the Fed could lower rates to stimulate the economy and get people back to work. Now that the labor market is strong and inflation is high, they are increasing rates to try to put the breaks on an economy that is producing too much inflation.
The major concern for the markets right now is how aggressive will the Feds get in raising rates. Will the Fed put the economy in a recession in order to lower inflation? That’s the main question the market is trying to figure out.
It’s an extremely delicate tight rope the Fed is walking. Increase rates too much the economy goes into recession. Don’t increase rates enough and inflation continues at this current unacceptably high level.
Virtually every moment of every day there are eyes on the Fed trying to get a feel for what direction they might go.
The ideal situation is that inflation starts to ease and the Feds can stop any further increases in the relatively near future. The market will likely breath a huge sigh of relief when they believe that the rate increases are mostly over. As investors we do not want to be on the sidelines when that happens (I can’t stress this point enough).
Is your head hurting yet?😉 I know this is complicated and nerdy, hopefully it’s making sense.
Ok, so what are we as investors to do with all of this? I know my advice here is not going to come as a surprise … hang in there, be patient, don’t get too stressed out about these short-term market fluctuations, ride out the storm.
A few weeks ago we had to hunker down as Hurricane Ian barreled through … the days that followed the storm were some of the most beautiful weather days we had experienced in quite some time. It was such a welcome relief after the stress of the howling wind rattling the windows for hours. I believe the same will be true here … we as investors just need to ride out the storm and there are beautiful days ahead.
As always, we are here to support you any way we can. Please do not hesitate to reach out with any questions / thoughts.
Make it a great week ahead!