- The Fed raised its benchmark rate by 0.25% at its most recent meeting
- This broke a trend of four consecutive meetings with rate increases of 0.75%
- Though inflation has eased, data shows that the economy remains very hot, which could provide upward pressure on prices
Investors and businesses closely monitor the Federal Reserve and how it adjusts the federal funds rate. The Fed meets multiple times yearly to decide how to manage the economy.
At its most recent meeting, the Fed opted to increase its benchmark interest rate by 0.25%. This breaks the 0.75% trend of hikes, which occurred after four consecutive meetings before this one, leaving investors to wonder about the future.
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The Federal Funds rate
The Federal Funds rate is a benchmark interest rate that impacts major aspects of the global economy. It is the interest rate at which banks lend money to each other overnight and influences rates for everything from savings accounts to credit cards and more.
The Fed uses various market activities to manage this rate and keep it close to a target it announces after every meeting.
When the economy is weak, the Fed lowers the rate to encourage borrowing and boost economic activity. Raising the rate, as the Fed has done recently, makes borrowing more expensive and can help fight inflation.
The Fed’s rate hike
On Tuesday, Federal Reserve Chairman Jerome Powell announced the Fed’s 0.25% interest rate hike, bringing the Federal Funds rate to a target range of 4.5% to 4.75%.
He noted the success of recent rate hikes at cooling inflation, saying, “The disinflationary process, the process of getting inflation down, has begun and it’s begun in the goods sector, which is about a quarter of our economy.” He added, “But it has a long way to go. These are the very early stages.”
This encouraged investors, who tend to hope that the Fed will stop raising rates. Stocks gained value during his speech. However, stocks began to fall shortly after Powell cautioned against being overly optimistic.
The most recent jobs report, which came out just after the Fed’s meeting, blew expectations out of the water. The U.S. added 517,000 jobs in January, nearly triple the expected amount. It also indicated that there are almost two jobs for every American looking for work.
This strong job market indicates that the economy is running hot, and inflation could continue.
It’s true that inflation has eased in recent months. After hitting a high of 9.1% in June of 2022, it dropped to 6.5% by the end of the year. However, it remains well above the 2% level that the Fed typically targets as a healthy level of inflation.
Though signs have been positive, there isn’t much clarity about whether inflation will continue to fall, especially because other economic news has pointed to the contrary.
In his statement, Powell noted, “The reality is we’re going to react to the data. So if we continue to get, for example, strong labor market reports or higher inflation reports, it may well be the case that we have to do more and raise rates more than is priced in.”
Powell did not indicate when rate hikes will stop, but he did mention that the Fed does not expect inflation to drop to 2% until some point in 2024.
One thing of particular interest to investors is Powell’s comment that the Fed has gotten more granular than before when analyzing inflation. There has been an increased focus on core products and an understanding that housing prices are elevated.
“We need to be patient,” said Powell. “We think we’re going to need to keep rates at a restrictive level for a period of time before that comes down.”
Rates play a significant impact in determining housing prices since most people rely on mortgages to buy homes. High rates lead to higher monthly payments for similar loans, which can cause home prices to drop since fewer buyers can afford payments on larger loans.
What it means for investors
The Fed’s most recent meeting was a mixed bag for investors.
An interest rate hike of just 0.25% is a significant slowdown from the Fed’s previous meetings, indicating that the days of big rate increases could be coming to an end. However, other economic data makes it hard to believe that high inflation will disappear overnight. This means that the Fed may need to take larger steps to intervene if the economy remains too hot.
Unfortunately, this makes it difficult for investors to figure out the best move going forward. Rate hikes tend to hurt the market, especially ones exceeding what the market expects. The Fed has slowed the pace of rate increases but indicated that anything is on the table if the economy remains hot.
Powell said, “Our message was this process is likely to take quite a bit of time. It’s not going to be smooth. It’s probably going to be bumpy, and we think that we’re going to need to do further rate increases.”
Investors should be ready for volatility because predicting how the economy will react to rate changes requires nothing less than a crystal ball.
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The bottom line
The economy has been in an unusual state since the onset of the COVID-19 pandemic. It’s seen a complete shutdown, massive crashes in stock prices, a strong recovery, massive stimulus payments and historically high inflation. The Fed’s management of interest rates is just another unpredictable factor for investors to deal with.
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