After raising the interest rate by 25 points on March 16, the Fed is looking to raise it by a full 50 points at the next policy meeting on May 4. Raising the interest rate at speeds faster than expected is an attempt to slow down rampant inflation that hasn’t been seen in 40 years.
In early 2020, the federal government created stimulative fiscal policies that put lots of cash into the market. Whether it be lending with zero interest, stimulus checks, or programs such as the Paycheck Protection Program (PPP), the extra cash on hand caused a large increase in spending, as it was meant to do.
At the same time, slower global production and uncertainty combined with varying levels of lockdowns and worldwide government policies created a huge surge in pent up demand. A very imbalanced supply chain and severe labor shortages contributed to the rising prices as well. All of this created a scenario where the price of everything shot up- from energy and food, to labor, transportation, and raw materials.
When the Fed announced that they would be raising interest rates throughout the year in order to combat inflation, they gave rough estimates of how many times it would occur and at what rate. But with the first March rate hike in the books and a 50 point rise set to occur, it is apparent that barring any big surprises, the Fed will raise interest rates as often as possible throughout the year.
But what does this all mean for CFOs and company finances? While many economists and government officials are certain that it will help bring down inflation and stabilize the economy, others have some doubts.
CFO Optimism
The economy and unemployment rates have made an unprecedented comeback since the bleak days of 2020, and the very strong economy will have no problem standing up to rising interest rates- even if they are larger than usual. The economy seems like it is only going to get stronger from here.
Stock market resilience is another reason why CFOs should not be concerned about rising interest rates.
In addition, bond yields have yet to rise as much as people expected, meaning higher stock prices and high levels of optimism for the future are still abundant, despite inflation and rising interest rates looming.
By 2023, inflation should be way down and reach far more stable levels of 2-3% instead of the 7%+ it is at now. Raising interest rates is the main step in achieving this, and cutting inflation at least in half is beneficial to everyone- especially CFOs who are aware of the steep costs of goods, transportation, and labor.
The Fed Open Market Committee (FOMC) and many economists have confidence that continuing to raise interest rates will help bring down inflation and increase stability. Most importantly, it won’t harm the economic recovery or capital markets. This is good news for CFOs, as the last thing companies need right now is renewed volatility after 2 years of being bombarded with challenges from all sides.
CFO Concerns
However, the Fed raising interest rates does not come without risks, especially with the speed and consistency that is planned for 2022.
A big concern is that the strong economic outlook is being fueled by the pent-up consumer demand and government stimulus checks that initially sparked last year’s huge economic growth. If that’s the case, then this growth is not completely natural and sustainable, and the economy may not be able to withstand the Fed raising rates as much as everyone wants to believe.
Another concern is geopolitical factors. China’s continued extremely strict Covid-19 policies have negative effects on the supply chain, being that it is the biggest exporter of goods in the world. For very different reasons, the Russian invasion of Ukraine and the consequent worldwide sanctions are causing massive supply chain disruptions in important categories such as wheat and oil. Neither of these geopolitical factors are showing signs of letting up and can greatly reduce the effects of the attempt to lower inflation.
The Fed’s history of having a hard time producing all of the effects that it wants when trying to take control of the economy and inflation is also something to look out for. Swinging the pendulum too far to one side can have unintended consequences and create economic instability despite the good intentions.
Last but not least is the labor shortage- one of the biggest and most lingering problems from the pandemic- and perhaps the biggest inflation concern for CFOs. No matter how much inflation is reduced, if a labor shortage still exists then companies will be forced to pay employees more than usual, with the rest of the workforce following suit. Since it might take a while for the employee shortage to even out, it can potentially cause inflation to stay up- even if the Fed is successful in lowering it by a few percentage points.
Additional things to look out for
Raising interest rates is not the only action that the Fed will take in order to reduce inflation. The Fed announced that it will start selling treasury and mortgage-backed securities from its balance sheet beginning in May. This is another way to reduce inflation as quantitative tightening as it is known, is a way to take money out of the economy which reduces the money supply and consequently inflation.
Another interesting thing to look out for is whether long term interest rates will rise as the Fed funds rate does. While during “regular” inflation this is almost always the case, the current inflation period is quite different. The trillions of dollars that were added to the economy (much of it now in excess savings), has caused there to be $2.4 trillion in US bond holdings in August 2021, a huge increase from the $64 billion before the pandemic. Although long term rates may remain fairly low for the short term (November and December 2021 bond auctions currently have a negative real yield thanks to such high inflation), this huge increase in bond holdings shows that people expect long term bond yields to increase.
All of the actions that the Fed is planning to take this year have consequences on individual households and businesses, independent of whether or not the economy will backtrack or stay strong after raising interest rates. There are a couple of consequences for businesses:
Before interest rates rise again throughout the year, companies should look for ways to reduce their debt, as it is about to get more expensive to pay off debt if not locked into a fixed rate.
On the other hand it might be a good idea to borrow now that the interest rates are low- if the time is right, the rate is good, and it's a fixed rate.
Short term interest rates will rise along with the federal funds rate, affecting short term consumer borrowing rates.
While some economists say that long term interest rates will remain low in the short term, which benefits companies looking to invest, the unbalanced short term rates will eventually push up bond yields and mortgage rates.
Conclusion
It is hard to predict what the consequences of the Fed raising interest rates will be throughout the year. While everyone agrees that this is the first step in getting inflation under control, there are so many factors involved (some controllable and some uncontrollable) that the short and long term implications are still unknown. As a CFO, it is best to be ready for all different scenarios in order to know how to take advantages of the upsides and be prepared to react to the downsides.
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