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Fed Taps the Brakes With Another Rate Hike

Can the central bank slow down inflation without crashing the economy?

Car speeding around corner.

Key Takeaways

As anticipated, the Federal Reserve raised its target rate by 0.75 percentage points for the second consecutive month to combat historic inflation.

Part of the battle is for hearts and minds because inflation expectations can be self-fulfilling.

Don’t get hung up on debates about what constitutes a recession. Commit to a strategy that prepares your portfolio for volatility before it happens.

The U.S. Federal Reserve (Fed) has continued its rate-hike campaign to tame stubbornly high inflation. The central bank raised its target lending rate another 75 basis points to a target range of 2.25% to 2.5%. The move marks the Fed’s fourth hike of 2022, matching June’s surprise 0.75% increase.

The Global Inflation Fight

We started seeing worrisome inflation data last year as the global economy heated up thanks to low-interest rates and government stimulus aimed at blunting the pandemic’s economic damage. Russia’s invasion of Ukraine in February added fuel to the fire with an energy shock and another jolt to fragile supply chains.

As a result, countries worldwide are wrestling with rapidly rising prices spurred by constrained supplies of consumer goods and spikes in food, housing and energy costs. In the U.S., inflation hit a 40-year high of 9.1% in June. Meanwhile, inflation rose to 9.4% in the United Kingdom and 9.6% in the European Union.

Central banks worldwide are trying to tamp down prices by raising borrowing costs. According to the International Monetary Fund, 75 central banks have raised interest rates in the last 12 months.1 This includes the European Central Bank, which recently announced it was raising its target rate above 0% for the first time in eight years.

Central bankers want to see wage growth and prices moderate, but not so fast that the economy tips into a severe recession.

Fighting Inflation Has a Psychological Dimension

The Fed’s effort to change how consumers and businesses think about rising prices is essential to the inflation fight. Mindset is vital because high inflation expectations can be self-fulfilling.

For example, when your grocery bill rises, the cost of a fill-up jumps, or your landlord raises your rent, you may ask your employer for a raise to keep up with the cost of living. Your employer, in turn, may try to offset higher labor costs by raising prices. If they can raise prices without hurting sales, they may be more comfortable doing it again in the future. Prices can spiral upward from there.

The Fed’s goal is to stop the spiral. Central bankers want to see wage growth and prices moderate, but not so fast that the economy tips into a severe recession. This moderation can be achieved if higher interest rates persuade consumers to save more and spend less, and businesses delay hiring and future investments.

This so-called “soft landing” has proven elusive in the past.

Fertile Ground for Volatility

Worries about the impact of higher rates and declining economic growth have spurred uncertainty and significant market turmoil this year. These conditions are challenging for companies on many fronts. How will higher rates and prices impact sales? Will their customers cut back on spending?

Rising rates and inflation also contribute to high costs and lower profits. In addition, a cloudy economic outlook makes investing in future business growth initiatives less appealing.

For our investment teams, rising rates and the softening economy place an even greater emphasis on developing a comprehensive understanding of a company’s fundamental and financial strength. As we noted in our most recent Investment Outlook, rising interest rates and falling equity markets have made debt and equity financing more expensive. Therefore, our teams must assess whether businesses have sound balance sheets and adequate capital to fund critical long-term growth initiatives.

Consumer Spending Remains Key

We’re also keeping a close eye on consumers, who account for roughly 70% of the country’s economic activity. With historically low unemployment and healthy personal savings coming out of the pandemic, consumers have proven resilient. However, we have seen signs of weakness.

Shoppers are choosing to cut back on discretionary purchases while a larger portion of their incomes covers inflated prices for day-to-day staples such as food, personal products and health care. While this trend hurts many retail stores, it’s less impactful for companies that offer everyday products and services. Such businesses have a history of being less economically sensitive and generating more stable profits.

Unchecked Inflation and Rising Rates Are Dual Threats

As investors, we’re encouraged by the rate hikes because they demonstrate the Fed’s recognition that inflation is sticky and a profound threat to consumers, businesses and the economy. Even though we believe the central bank erred in waiting too long to act, we think its aggressiveness now demonstrates a commitment to bringing inflation under control.

The market constantly assesses whether these policy measures are working to achieve a soft landing. Are the Fed’s actions too little too late? Or are the increases too much too fast? We expect continued volatility as investors search for clues in economic, employment and corporate earnings data.

Don’t Get Caught Up in the Definition of Recession

The Fed’s latest maneuvering comes amid a technical and political debate about what constitutes a recession. One common view is that two consecutive quarters of shrinking gross domestic product (GDP) indicates a recession.

On the other hand, many economists rely on the National Bureau of Economic Research (NBER) to declare a recession. NBER takes its time in making a recession determination and considers a broader range of economic data. Factors include wage and jobs growth, which have been robust in 2022.

In our view, the technical term describing what we’re experiencing doesn’t have a practical impact on most of us. No matter how you label it, this uncertain backdrop creates the potential for volatility in the capital markets.

We urge investors to apply discipline and avoid impulsiveness. We think it’s wise to prepare for wide swings in the market before they happen. You can do this by committing to a long-term asset allocation strategy designed to account for high inflation, rising interest rates and economic risks. We believe such an approach benefits investors regardless of experience and sophistication.

Victor Zhang
Victor Zhang

Chief Investment Officer

Senior Vice President

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Kristalina Georgieva, “Facing a Darkening Economic Outlook: How the G20 Can Respond,” International Monetary Fund Blog, July 13, 2022.

The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.