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Historically-high inflation rates have pushed the Fed to increase interest rates. Such increases affect farmers by increasing the cost of capital for loans used for buying inputs, covering operational costs, or purchasing land.
This happened at the same time that farm input costs were also increasing due to the Russian invasion of Ukraine, major producers of oil and fertilizer. Recent inflation figures show that the Fed's aggressive policies may be taking effect, and the future hikes in interest rates could be smaller than the hikes seen since March 2022.
The federal funds rate is the interest rate at which commercial banks borrow and lend their excess reserves to each other overnight. The Federal Open Market Committee meets eight times annually to set the target for this rate, part of its monetary policy. The Fed bases this decision looking at two indicators: unemployment and inflation.
A low interest rate promotes economic growth, which reduces unemployment. On the other hand, a low interest rate increases the flow of money into the economy, increasing inflation. That means that the Fed needs to find a balance, setting a rate low to keep maximum employment but not too low to raise inflation above their 2% target. The federal funds rate determines many other interest rates in the economy, like mortgage and bond rates, directly or indirectly.
The Consumer Price Index (CPI) is one of the metrics used by the Fed to make decisions about interest rates. On December 13th, the Bureau of Labor Statistics released its estimates for November CPI.
The report stated that CPI increased 0.1% in November and 7.1% from a year ago, while core inflation (without energy and food) was 6%. These numbers indicate a reduction in annual inflation for the second time, from the releases for September and October when annual inflation was 8.2%, and 7.7%, potentially indicating a downward trajectory. The reduction occurred across different categories – food, energy, and core inflation (all items without food and energy) -- which could signify the decline is happening all over the economy.
It is essential to recognize that the inflation reduction does not mean prices are decreasing. Prices are still increasing, but at a slower pace than before. These inflation numbers were better than what the market expected and were interpreted as an indication that while inflation is still high, it could start to cool.
In the same week, on December 14th, the U.S. Federal Reserve announced the rise of the federal funds rate by 50 basis points, increasing their benchmark interest rate from 4% to 4.5%. This is the sixth meeting this year they have raised rates in an attempt to combat swelling inflation, but it is a step down from the 75 basis points seen over the previous four meetings. The Fed also continued with the quantitative tightening program that it has been doing since mid-summer, which means they continued to reduce their balance sheet to a cap of $60 billion per month for their U.S. treasury holdings and to a cap of $35 billion per month for mortgage-backed securities. Quantitative tightening also contributes to driving interest rates upwards.
Among their most important announcements is that they anticipated that increases in rates will continue next year, as there is a need to return inflation down to the 2% target. This was taken as a negative sign by the markets, who were expecting signs that the Fed would slow down their interest rate increases. That generated a market response, with most stock indexes reducing their values following the report (S&P 500 -2.05%, Nasdaq -2.41%).
In 2022 the federal funds overnight rate went from 0.25% at the beginning of the year to 4.5% after the last meeting. This is the most rapid increase in interest rates since the early 1980s (graph). The 30-year mortgage rate is now at 6.33%, a bit below the peak of 7% it reached in November, which was a record-high interest rate since 2002.
It is too early to tell.
Although the last CPI report was a positive sign, inflation is a complex phenomenon and depends on multiple prices that are volatile. Many more downward reads are needed to detect a trend.
Additionally, the 7.1% inflation rate is still well above the Fed's 2% target, which indicates that it will take time for the Fed's actions to bring inflation down to the target successfully.
One way we can get a consensus for future expectations is to look at the Fed Funds Futures. These are financial futures contracts traded on the Chicago Mercantile Exchange (CME), reflecting market expectations about future changes in the Fed funds rate. After the announcement, the Fed funds futures market shifted its expectations, delaying the expected rate peak and how long it will last. Currently, the market anticipates that the Fed rate will peak at 5% in June 2023 and that the Fed will slowly start reducing it in the following months.
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