On June 15, 2022, the Federal Open Market Committee (“FOMC”), a branch of the Federal Reserve System (the “Fed”) raised the federal funds rate by 0.75 percentage points (or 75 basis points). This was a significant event in a few ways. First, it marked the largest interest rate increase since 1994. Second, it was a departure from the usually precise previous comments made by many members of the FOMC which indicated a 50 basis point increase. The rate increase was a reaction to high inflation. Consumer Price Index (“CPI”) was 8.6% in May 2022, a 40 year high.
The Fed is the central bank of the United States and is charged with conducting national monetary policy. Given its role, the Fed has a significant impact on economic and market trends worldwide. The fed funds rate is the overnight loan rate which banks charge each other to loan money to comply reserve requirements. The fed funds rate is one of the most significant tools used by the Fed to manage inflation. The large rate increase is a departure from prevailing monetary policy of the past decade known as “quantitative easing.”
Why does it matter?
The fed funds rate is the most key metric to understanding systemic risk, the undiversifiable risk attributable to a system and not its individual parts. Systemic risk is the fundamental base at which risk is evaluated for all assets. Across the board, discount rates are up which makes capital more expensive effecting businesses and individuals alike.
The effects can be observed in the market. Treasury bond yields have risen dramatically from levels observed in 2022. It is a common misconception that the Fed sets these rates. Despite the Fed’s influence in the market as a large trader, this is a market reaction. Additionally, the yield curve remains inverted (a phenomenon where short term yields are higher than long term yields), a troubling sign. Interest rates on loans have risen and are likely to continue to rise. The S&P 500 has lost 15% of its value in the year-to-date. We may have experienced the worst from a market standpoint. This announcement was anticipated and all major indexes actually finished higher at close on the day of the announcement. Barring more significant rate increases than currently anticipated, the Fed’s actions may have a less crucial direct impact on the market going forward.
Consequential economic effects are likely to be seen. Companies that were once rich in working capital post-pandemic are likely to tighten spending and investment. The trend of low unemployment experienced in 2021 and early 2022 could reverse. The uncommon negotiating power that workers have right now may begin to shift back to a more normal balance. The full extent of the impact will continue to play out over time as the Fed seeks to cool off a red hot economy.
Corporate mergers & acquisitions are likely to slow down as companies become more capital conscious. High valuations for riskier tech companies are likely to become a thing of the past for now. Private equity may experience less disruption however. With a lack of return in the public market, more capital may move to private equity funds in search of returns. Expect that an emphasis will be put on consistent, low volatility investment companies.
Where do we go from here?
Comments from Fed officials indicate a likely 175 basis points of additional increases in 2022, up 100 basis points from similar projections in March 2022. Jerome Powell has indicated that he is striving for a “soft” or “soft-ish” landing, an allusion to an outcome that doesn’t involve a recession. There is a tight window between two scenarios of too much or too little intervention, both of which could trigger a recession. Time will tell and the full extent of the impact of monetary policy won’t be known for up to a year.
Companies should practice strong fiscal discipline and strive to make decisions on logic instead of emotion. Uncertain times create opportunity for those who can manage risk. The companies that will perform strongly over the coming years are those that practice fundamentals such as strong internal controls, financial planning, budgetary discipline, and wise investing. Failing to plan is planning to fail. Where will you and your business be in five years? What are you doing today to get there? Do you have an exit & succession plan? What is your firm’s strategy? Does it incorporate ESG? How do evaluate investment decisions? All important questions to discuss with your team of advisors. DKB’s Business Valuation & Advisory practice is well positioned to help clients navigate uncertainty and achieve their goals.