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The Fed’s Rate Treatment and More Economic Threats

The Federal Reserve’s rate policy outlook and other risks are testing the resilience of the U.S. economy.

10/10/2023

Key Takeaways

The market didn’t seem to expect the Fed’s plan to keep interest rates higher this year and into next year.

The Fed is using higher rates to get back to its desired inflation rate of 2% and get the U.S. economy on the path to recovery.

A potential government shutdown, ongoing industry strikes and restarting student loan repayments also pose a risk to the economy.

No Rate Hike, but Higher Rates for Longer

At its September interest rate policy meeting, the Federal Reserve (Fed) reiterated what we already knew but the market refused to hear—rates are staying higher for longer.

But investors didn’t like the fact that Chairman Powell made sure to emphasize three things:

  1. Rates will remain higher for longer than the market is currently expecting.

  2. The Fed is not opposed to hiking again later this year if needed.

  3. They now project fewer rate cuts in 2024—only 50 basis points, in fact.

So yes, we had another pause in monetary policy but with a definite hawkish tone. I think Chairman Powell did an excellent job of stating the Fed’s current position and pushing back on the notion that we’re out of the woods, economically speaking.

The Fed’s Prescription for the U.S. Economy

The analogy I think that works best to understand the Fed’s stance right now is the medical one.

The patient is the U.S. economy, and although it’s apparently fairly healthy right now as measured by gross domestic product (GDP) growth, it has recently gotten over a pretty bad illness (as evidenced by the COVID-19 recession and last year’s bear market).

The lingering problem remains inflation, which is essentially like a nagging fever that the patient can’t seem to get rid of. Yes, the fever (as measured by inflation) is coming down, but we are not yet back to normal levels. That’s 98.6 degrees for a human, or 2% inflation for the economy according to the Fed’s stated inflation target.

That is why Chairman Powell continues to harp on the desired inflation rate goal of 2%. While inflation has been coming down recently, it needs to get to 2% before the Fed stops administering monetary antibiotics in the form of higher rates.

The Fed will not declare this economy at full health until inflation reaches 2%. Recent progress toward that goal is a good sign, but the job is not done. We don’t believe the patient will be released from the hospital until we get there. In other words, we must remain on the medicine of high rates until we get back to a normal temperature.

More Potential Economic Threats Ahead

Shutdown, strikes and student loans—or the three “S’s” as we are calling them—all pose additional threats to the economy.

Shutdown

The first “S” refers to the possibility of a government shutdown. Although Congress narrowly avoided a shutdown at the beginning of this month (with funding extended through Nov. 17), the fear of it happening will continue to hang over stock prices like a cloud.

In economic terms, we’ve seen estimates that for every week the government is shuttered, 0.1% would come off fourth-quarter GDP. In political terms, the current difficulty in financing the government would seem to validate the Fitch rating agency’s August U.S. credit rating downgrade, which specifically cited “the erosion of governance…manifested in repeated debt limit standoffs and last-minute resolutions.”

Strikes

The second “S” refers to the UAW and WGA/SAG strikes. In September, the Writers Guild of America reached an agreement with the major Hollywood studios to end their nearly five-month-long strike. Nevertheless, we’re not back to business as usual in Tinseltown because actors remain on the picket lines. They’ve been out since mid-July, and the effect of lost wages and follow-on spending continues to mount.

The economic impact of the autoworkers’ strike is similarly hard to gauge. One prominent estimate by Anderson Consulting is that a 10-day strike against all the Big Three automakers could cost the economy $5 billion. Both Ford and General Motors stocks have already taken a hit because of the labor action.

Student Loans

The last “S,” which is a certain hit to economic growth this year and early next, is student loan debt repayments. Sitting on $1.6 trillion of debt owed to the government, Americans with student loans have enjoyed a break from both repayments and interest since March 2020.

But the repayment holiday is over as a result of the Supreme Court’s ruling that the Biden Administration didn’t have the authority to forgive hundreds of billions of dollars of student debt. Interest on those loans started to accrue again in September; repayments will resume this month. Given that there are about 43 million borrowers, this represents a very real drag on the American economy.

Exactly how big the drag will be is a matter of debate. In 2017, the Fed calculated that the average monthly payment on student debt was $393.

But that number excluded the roughly 40% of the student debtholders with one or more loans in deferment. If we took $393 and multiplied by all borrowers, that would add up to a total monthly repayment of $17 billion, or about 1% of household consumption. Assuming that only part of the repayments comes from savings, that would imply a cut to America’s quarterly annualized growth rate of 0.7 percentage points. That’s a reduction we can ill afford right now heading into a slowdown.

Separately, a Moody’s credit rating report came up with a lower, but still sizable, hit to economic growth. Moody’s estimated a $275 monthly payment by five million Americans. By their calculus, that equates to a 0.25% hit to GDP growth.

Author
Richard Weiss
Richard Weiss

Chief Investment Officer

Multi-Asset Strategies

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