Higher rates were cooling prices — and then things got complicated

Source: US Bureau of Labor Statistics, 12-month percentage change, Federal Reserve Bank of St. Louis, as of April 2023.

On That ‘90s Show, as Red and Kitty’s computer dials the internet — screeching and hissing toward a connection — the characters slump back on the couch to wait. That’s how the fight against inflation has felt, too — like it’s taking a long time and there is little we can do but wait for the Federal Reserve’s actions to have an effect. Now, with the closure of Silicon Valley Bank and Signature Banks , the Fed’s job has become more complicated.

When inflation began to rise in 2021, Fed officials didn’t think inflation would stay above their 2 percent target for long. They believed prices would naturally drop as pandemic-related supply chain issues were resolved. However, by December of that year, inflation had become stickier. Prices paid for goods and services that are normally slow to respond to inflation — rent, medical care, and home goods — began to move higher.

That forced the Fed to act. In 2022, it stopped buying bonds and began to reduce its balance sheet, a process known as quantitative tightening. In addition, the Fed began to raise rates. Since March 2022, the Fed has raised the federal funds rate nine times, increasing rates from near zero to 4.83%.¹

Rate increases take 12 to 18 months to affect the economy

The federal funds rate is an important weapon in the war on inflation. When the Fed pushes the federal funds rate higher, it influences the economic cycle. Borrowing becomes more expensive as rates on credit cards and loans increase. Then, people and businesses begin to spend less, pushing demand for goods and services down. Often, lower demand for goods leads to layoffs and that means even less spending, which causes prices to drop.

While rising rates are expected to drive inflation down, there is a lag time between the Fed’s actions and inflation moving lower. It usually takes 12 to 18 months for Fed actions to work their way through the economy. In this case, the United States economy has proved to be quite resilient despite the Fed’s efforts. While economic data suggests those actions have had some effect, inflation remains well above the Fed’s 2% target.

The Fed’s efforts have been complicated by fears that were triggered by the collapse of SVB and Signature Banks. In addition to balancing persistently high inflation against economic growth, the Fed must now factor in financial stability concerns.

Uncertainty about future of rate increases and upheaval in financial markets have created opportunities for investors who embrace risk, while rising interest rates have created opportunities for investors who are risk averse. If you would like to talk about opportunities that might benefit your portfolio, contact your CIBC Private Wealth professional.