This is a Pretty Good Moment for the Economy - October 1, 2018

The title is a comment that came from Fed Chief Jerome Powell. He made the remark at last week’s quarterly press conference, which followed the Fed’s decision to hike the fed funds rate by 0.25% to 2.00-2.25%. It’s the eighth quarter-point rate hike since the Fed began boosting the key rate in late 2015.

10 1 18 index

The economy no longer needs a fed funds rate near zero in order to support economic growth. Today, the economy is expanding at a healthy clip, and central bankers are in the process of gradually normalizing interest rates.

While interest rates aren’t far from historically low levels, rising rates are finally beginning to offer some savers a more reasonable return.

But are rising interest rates an impediment for stocks? The conventional wisdom argues that a tighter monetary policy creates a stiff headwind for stocks. But is the conventional wisdom backed up by the recent data?

The graphic below stacks up S&P 500 Index performance with the series of rate increases that began almost three years ago. While the Fed has been lifting interest rates, the S&P 500 Index is near an all-time high.

10 1 18 stocks and interest rates

What’s going on? The gradual approach by the Fed has played a role in limiting any negative impacts, but the underlying reason for lifting rates – upbeat economic growth – is underpinning shares.

Economic growth supports profit growth, a key component for long-term stock market performance. Further, solid economic momentum has enabled the economy to absorb higher borrowing costs, at least so far. If rate hikes were in response to higher inflation, market reaction might be much different.

Long story short, the S&P 500 Index is up 41% since the first rate increase (through 9.28.18).

A delicate balancing act

Raise rates too quickly and the Fed risks throwing the economy into a recession. Raise too slowly, and the economy might overheat (expands too quickly), heightening the risk of higher inflation. Thus far, the Fed has managed to thread the needle.

Looking ahead, the Fed’s own forecasts project that low unemployment and low inflation will continue through 2021. Such a scenario would be supportive of shares. But, Powell repeatedly pointed out that forecasts that far in advance have a high degree of uncertainty. Agreed.