[InvestingAnswers Feature: Are You Prepared for the Coming Great Inflation?]
The Federal Reserve is in charge of combating inflation via monetary policy. It has several tools in its arsenal, but the main way the Fed controls the rate of inflation is by raising and lowering very short-term interest rates.
Since December 2008, the Federal Reserve has been trying to get the U.S. economic engine back to full power. It lowered short-term rates to zero in order to encourage banks to make loans to businesses. In theory, banks will borrow money from the Fed at very low rates (think 0%), loan the money to small business at higher rates (5% or higher), and keep the difference as profit. That's how banks make money.
Unfortunately, if the banks lend out too much money, inflation can start to creep up. Low rates are thought to have led to the recent catastrophic housing bubble that pushed the U.S. economy into a deep recession. And those increasing food prices mentioned earlier might be an indication that inflationary pressures are starting to build again. So to paraphrase former Fed Chairman Alan Greenspan, it may be time to take away the proverbial punch bowl before this party gets out of hand.
Talk of inflation and interest rates naturally lead to 4 questions on the minds of consumers and investors. After pondering the most common questions, I'm willing to go out on a limb with what I believe to be the most probable answers:
Q: When will the Fed start to boost interest rates?
A: Sooner rather than later.
Interest rate policies are actually set by a group of Fed officials. (Click here to read 12 Powerful People Control Your Destiny -- What Are They Trying to Tell You?). A few members think they should have raised rates months ago because the recent spike in food and energy prices are bound to boost inflation across the rest of the economy. Another contingent is worried about the opposite happening; they worry the economy is still so weak that any increase in rates will send the economy back into recession, or even a depression.
The remaining Fed members are somewhere in the middle. It's these swing votes that are the ones to watch, but among market watchers, the general consensus seems to be that rates will need to go up by the end of this year to stave off inflation concerns in 2012.
Q: How high will rates go?
A: The Fed funds rate may get close to 3% by the end of 2012.
If the Fed hikes rates, it will start slow. Minneapolis Fed President Narayana Kocherlakota recently predicted to Bloomberg that the Fed will hike rates by 50 basis points (0.50% in layman's terms) by the end of the year. Economists generally think rates will rise another 1-2% in 2012. That would put the Federal funds rate at close to 3% by the end of next year. That's actually still quite low by historical standards. In the 1970s, interest rates soared into the double-digits.
Q: How will it affect the economy?
A. As mentioned, a small rise in interest rates is unlikely to hurt the economy.Businesses and consumers are unlikely to change their spending patterns if the Fed funds rate is just 3% or 4%. And for savers, rate hikes would be a blessing when they start to earn higher interest from their fixed-income investments (CDs, bonds, etc.).
An increase in rates is also likely to provide support for an ever-weakening dollar. Foreign investors buy bonds that offer solid yields. Many foreign investors have been buying bonds from countries like Brazil because they offer especially high yields. Brazil is already dealing with the inflationary pressures feared in the U.S. and its finance ministers are looking to slow down a blistering economy by keeping rates quite high.
Q: What does it mean for stocks?
A: Paradoxically, a moderate rise in rates would be good for stocks.
That's because many investors fret that the economy remains in a very fragile state, and are loathe to buy stocks while we're at risk for further economic weakness. Rising rates would signal that the Fed, which has deep insights into the economy, sees a strengthening economic picture that is built to withstand rising rates.
The Fed hiked its key lending rate from 2% in late 2004 to 5.25% in June 2006. In that time, the S&P 500 rose from around 1,150 to 1,270, a 10% gain. But if rates keep rising beyond that point, and investors think that inflation is not under control, then stocks could take a sharp hit. The 1970s are considered to be a lost decade for stocks, in part because inflation and interest rates rose ever higher. Such a move look unlikely at the moment, but investors should keep a close eye on inflation and interest rate trends over the next 12 to 18 months.
The Investing Answer: Fed officials are required to disclose their thoughts to the public through formal statements, and the Fed Chairman, Ben Bernanke, reports to Congress on a regular basis. Additionally, individual Federal Reserve officials often talk individually, making their views known through individual interviews or speaking engagements.
If you can see where the decision-makers are coming from and where they want to go, future interest rates, especially short-term rates, can be somewhat predictable. Interest rates are one of the market inputs that regular Joes have a fairly good chance of forecasting, due to the public nature of Federal Reserve disclosures. Keep an eye out for news articles that report what Fed officials are saying. You probably won’t be able to use the information to get an inside track on Wall Street, but you can use it to make high-impact personal decisions, like refinancing your mortgage while rates are still low, or buying stocks if it looks like interest rates will stay in the 3-4% range.