MIKE TOWNSEND: Like a lot of you, I’ve been struggling to process the images from Ukraine over the past week. The lines of Russian tanks heading towards Kyiv. The bravery of ordinary Ukrainians picking up arms. The heartbreak of families separated, of lives uprooted, of buildings destroyed, of schoolchildren huddling in subway stations being used as makeshift bomb shelters. The human toll of this insanity is beyond measure. And over the weekend, we had the chilling reports that Russia had put its nuclear arsenal on a heightened state of alert.
The strong and rapid reaction of the world has been something to see. The United States and the European Union moved surprisingly quickly to put harsh economic sanctions in place and provide military, logistical, and humanitarian support.
Here at Charles Schwab, our job is to watch how the markets are reacting to this, to try to understand and explain the ramifications that are and will continue to ripple across the globe. Last week we saw oil briefly hit its highest price since 2014. We’ve seen volatility in the equity and bond markets, though some of that had tempered significantly by the end of last week. Emerging-market currencies have plunged. We’ve seen concerns about exports and supply chain impacts. Ukraine is the world’s third-largest exporter of wheat and fourth-largest exporter of corn, as well as a key exporter of things like neon gas that is critical to the production of semi-conductors. We are only beginning to see the impacts the most serious geopolitical crisis in decades could have on the global economy.
And while the war in Ukraine continues to unfold, there is plenty of other news for investors to process, including efforts in Washington to curb inflation, a reset of his domestic agenda by President Biden in Tuesday’s State of the Union speech, and the comments of the Federal Reserve chair as he testified on Capitol Hill this week and prepares to convene with the rest of the central bank leadership in less than two weeks for a meeting at which it is expected that the Fed will begin increasing interest rates for the first time since 2018.
All of it has combined for one of the most uncertain investing environments in years.
Welcome to WashingtonWise, a podcast for investors from Charles Schwab. I’m your host, Mike Townsend, and on this show, our goal is to cut through the noise and confusion of the nation’s capital and help investors figure out what’s really worth paying attention to.
While the Russia-Ukraine situation will continue to impact the markets in the days and weeks ahead, today I want to turn attention back to what’s likely to impact the U.S. markets most directly. Coming up in just a few minutes, I will welcome back to the podcast Kathy Jones, Schwab’s chief fixed income strategist, to walk us through what to expect from the Federal Reserve meeting later this month and how investors should approach a period of rising interest rates.
But first, a very quick update on some of the other issues grabbing the headlines here in Washington.
As expected, Congress did indeed approve a three-week extension of government funding prior to breaking for the week-long Presidents’ Day recess. That means the new deadline for averting a government shutdown is the end of next week, March 11. Members of the appropriations committees in both the House and Senate are scrambling to finalize the details of a massive omnibus bill that will bring together all 12 appropriations bills to fund every government agency and program for the remainder of this fiscal year. Given the complexity of that process, I would not be at all surprised if Congress had to pass another extension for a week or two before passing the final funding bill. I continue to think a government shutdown next week is highly unlikely.
But there is one factor that could accelerate these negotiations. Last weekend, the White House asked for at least $6.4 billion in aid for Ukraine to be added to the package—and some on Capitol Hill have called for as much as $10 billion. The desire among both parties to get aid to Ukraine quickly could act as a catalyst to get the broader spending agreement across the finish line next week.
I’m also watching the ongoing stalemate in the Senate Banking Committee over confirming the five nominees to the Federal Reserve Board of Governors. Last month, the committee met for a seemingly routine series of votes to confirm Jerome Powell to a second four-year term as chair, Lael Brainard as vice chair, Sarah Bloom Raskin as vice chair for supervision, and Lisa Cook and Philip Jefferson to fill the final two vacancies on the seven-member board. But Republicans, who object in particular to Raskin’s nomination, boycotted the meeting, leaving the Democrats short of the quorum necessary to take any votes. Those votes on the nominees are the last step before a final confirmation vote by the full Senate.
Earlier this week, the committee’s chairman, Senator Sherrod Brown, a Democrat from Ohio, said he would try again—and again the Republicans announced their intention to boycott the meeting. Brown ended up cancelling that meeting, but he says he’ll continue to schedule meetings until a Republican shows up—he only needs one of the 12 Republicans on the committee to do so in order to have a quorum. President Biden also weighed in on the standoff during his State of the Union address, specifically calling on Republicans to confirm the nominees because of the important role the Fed plays in combatting inflation.
The situation is one of the perils of the 50-50 tie in the Senate. Typically, committee seats are proportionately allocated, with the majority party having at least one more seat on each committee than the minority. But in a 50-50 tie, all of the committees have equal numbers of Democrats and Republicans. So if the Republicans don’t show up, the committee can’t move forward with its business.
Frustration is high on the Democrats’ side of the aisle, as they feel that the Republicans are unnecessarily tying up the nominations of less controversial nominees to make political points about one nominee. Powell, for one, enjoys broad bipartisan support. But Republicans are using the leverage they have to see if they can pressure the administration into dropping Raskin from the slate of nominees, or at least delay her nomination so they can ask more questions about her background.
Right now, it’s not clear how this will end. More importantly, it’s not clear when it will end. And the reason that matters is because of the Fed meeting coming up in less than two weeks. As it stands now, only four of the seven seats on the Fed Board of Governors are filled, and Jerome Powell is in an acting chair role because his term as chair ended in February. While the Fed is of course fully functional in its current configuration, there is no doubt that the central bank would like to have a full roster of governors in place as it heads into some of the most consequential monetary policy decisions it has made in years. But that looks increasingly unlikely to happen before the March meeting.
Finally, I’d be remiss if I didn’t mention the historic nomination of Judge Ketanji Brown Jackson as the first Black woman to be nominated to the Supreme Court. While the nomination of Judge Jackson may not have any impact on the markets, it will occupy a considerable amount of time and energy in the United States Senate over the next six to eight weeks, which is likely to impact the Senate’s ability to focus on other issues.
In the coming weeks, look for Judge Jackson to make the rounds of the Capitol for individual meetings with senators, followed by a confirmation hearing before the Senate Judiciary Committee later this month, though dates for the multi-day set of hearings have not yet been officially announced. A full Senate vote should come in April, though there is not much time pressure here since Justice Stephen Breyer has said he will stay through the end of the high court’s current term, which should end in late June or early July. It appears likely that Jackson will win the support of all 50 Democrats and could win the approval of a handful of Republicans as well. Her confirmation would not change the 6-3 advantage conservatives have on the court, but it’s an important historical moment.
On today’s Deeper Dive, I want to take a closer look at the Fed’s upcoming meeting and the central bank’s plan to begin raising interest rates to combat inflation. But what does that really mean for investors? Who benefits? How quickly will we see measurable impacts on inflation? These are just a few of the questions on investors’ minds as we head into this important new cycle.
So to help us better understand the impact of rising rates on investors, I’ve asked Kathy Jones, Schwab’s chief fixed income strategist, to return to the podcast. Kathy, I know it’s been a very busy few weeks, so I really appreciate you making the time to talk with me today.
KATHY JONES: Thanks for inviting me, Mike.
MIKE: So, Kathy, let’s sort of set the table here, starting with the Fed Open Markets Committee, usually referred to by its acronym, FOMC. They have a meeting on the 15 and 16th this month, and they’re expected to vote to increase interest rates. So who will be doing the actual voting?
KATHY: It’s always a little confusing because we hear about the Fed or the FOMC, but very few people know who most of these people really are. The committee consists of 12 voting members. They’re all either PhD economists or experienced in banking, in finance, or business. There are seven members on the Board of Governors, the president of the New York Fed, and then four of the remaining 11 Reserve Bank presidents. The head of the New York Fed is always a voting member, but the other regional Fed presidents rotate annually.
So the key players are the chair, Jerome Powell, the vice chair—who is nominated to be vice chair, Lael Brainard—and John Williams, president of the New York Fed. They kind of operate like the CEO, CFO, and COO when it comes to the Fed; however, everyone has a voice, and there are some very strong voices this year at the Fed. The most vocal about hiking rates are the St. Louis Federal Reserve President Jim Bullard and Chris Waller, a member of the Board of Governors. But the near universal consensus is that the Fed will start to raise rates at the meeting. I will say, since the outbreak of the Ukraine war and the sanctions imposed on Russia, there may be some concerns that now isn’t a great time for the Fed to be raising interest rates because of the uncertain economic outlook, but most believe it will happen.
MIKE: Well, as you say, most strategists expect that they will raise the rate. But let’s talk about what we mean when we say “the rate.” These aren’t rates that individuals are dealing with for car loans, or mortgages, or what we pay in credit card interest. This is the fed funds rate. It’s the amount of interest that banks and credit unions pay to other banks and credit unions to borrow money overnight. So why is this important, and how does it affect the rates that individuals actually deal with in their daily lives?
KATHY: Well, the fed funds rate is the base rate determined by the Fed, and all other interest rates are set off of it, so that’s why it’s important. It’s, essentially, the interest rate that’s the foundation for all Treasury yields and, therefore, other interest rates. The most direct linkage for individual investors is to rates on very short-term T-bills or money market funds. Those are generally just a little bit higher than the fed funds rate. After that, it’s kind of a ripple effect. So, usually, a one-year T-bill will pay more in yield than a money market fund, since your money is tied up for longer, and you should get compensated for that. And on it goes, all the way out to 10- and 30-year bond yields. But it also affects the cost of borrowing. For example, if the fed funds rate moves up, then it’s likely that the bank will charge more to lend you money for, say, a car loan or a mortgage. The bank is just passing its higher cost along to you.
MIKE: Well, how long does it take for those rates to kind of work their way down to consumers?
KATHY: Oh, it can happen pretty quickly, in a day or a few months at most. Borrowing costs tend to go up pretty fast, as lenders tend to pass those along quickly. Yields on savings might take a bit longer. Banks might wait to raise CD rates, for example, that they pay out to investors, if they don’t need the capital right away. But eventually, yields will typically move in the same direction, even if not proportionately or simultaneously.
MIKE: So at this meeting coming up later this month, they’re going to vote on this rate, and it could be a 25-basis point increase—it could be more—but we know it won’t be one-and-done. Do you think the Fed has a roadmap already in mind, kind of this many hikes this year, with a goal of getting to a specific level, ultimately?
KATHY: Well, the Fed does provide a roadmap of sorts. At every other meeting, it compiles estimates for where the members expect the fed funds rate to go over the next few years, and they also put together projections for the economy and inflation. We look at these estimates, and usually what we do is take the median and assume that’s the most likely path. But in reality, the Fed is just following the economic data like the rest of us, so the estimates can change. Based on what we’ve heard recently, some Fed members favor moving the fed funds rate from, you know, 0% to a ¼% range to 1% pretty quickly, even by summer. Eventually, the Fed has said that it thinks the optimal, or neutral rate, as they call it, is around 2½% But they’ve been saying that for years, and that’s the level for them, in theory, that allows the economy to grow without overheating and causing inflation.
But let’s be clear: None of this is written in stone. It can change really quickly. If inflation is higher or more persistent than expected, the Fed could raise rates rapidly to higher levels. If the economy and inflation cool off, it could pause hiking rates or slow down the pace. It really just depends on how things are going in the economy.
MIKE: Well one of the goals of raising rates is to curb spending, which means slowing the economy in order to bring prices in line. But, Kathy, are individuals really spending too much, or is this a supply problem in which the circumstances are forcing people to pay much more than they did last year for the same thing? What areas of consumer spending are higher rates meant to slow?
KATHY: Well, I think you’re right, Mike. In this cycle, it really has been a problem with supply. You know, you always think of inflation as a result of an imbalance between supply and demand. We’ve had a supply problem since the onset of the pandemic. The car makers aren’t getting enough inventory of cars because the plants that produce the chips in Asia aren’t fully functioning. So car production has been delayed, and that means the prices of the cars that are available are rising. It’s also pushed up the price of used cars to astounding levels. On a year-over-year basis, they’re up 40% in the last couple of months. But, meanwhile, demand has held up pretty well because a lot of people accumulated savings during the pandemic and want to spend it now, even though there aren’t enough goods to spend it on. The story is the same for, say, houses. There just hasn’t been enough in the way of materials and labor to keep up with the demand, so prices for existing houses are rising very fast.
What the Fed can do by raising rates is make it more expensive to borrow for those purchases, which slows down demand. Even though people will be buying goods, many will eventually get priced out of the market, or the prices of those houses and goods will have to fall to a level where people can afford them. Now, I remember this: My first mortgage was a 14-5/8% adjustable rate. Now, we were able to pay that much interest because the price of the house we bought had fallen in price enough to make the monthly payments affordable. But it was down about 25% from where it was originally priced. That was in the early 1980s, and there weren’t a lot of houses selling because the financing costs were so high. That could happen again if mortgage rates move high enough and stay high long enough. It eventually curtails demand, and then companies produce less because there’s less demand, and the economy slows down.
The Fed can’t solve the problem of too few computer chips or too little lumber. It can, however, reduce aggregate demand by making the cost of doing business or making purchases high. Eventually, that translates into slower growth, or possibly even a recession. But that’s how the Fed brings down inflation. That’s why there’s an old saying that monetary policy is a blunt tool. It hammers everything at the same time. It isn’t a finely tuned process.
MIKE: What about how this will impact individual investors? Will rising rates actually be a benefit to fixed income investors, or people holding funds in money market accounts, or bond funds, or individual bonds?
KATHY: Yes, it should be good for bond investors, in general. Savers, people who invest money to earn interest, should earn more interest as rates rise. The yield on money market funds will likely move up soon after the Fed hikes rates, also CD rates and T-bill yields. For investors looking to invest in bonds, there should be more attractive yields offered. However, if you currently hold bonds or bond funds, the price you can get for those bonds might fall as yields move up because the newly issued bonds would have higher yields. Nonetheless, for long-term fixed income investors, rising interest rates are generally positive because it means there are opportunities to earn more income on your portfolio.
You know, we hear from a lot of clients who have been waiting years for more attractive yields on muni or corporate bonds. When I talk to bond investors, especially those in retirement who want to use the interest on their bond portfolios for living expenses, they’re eager to get those higher yields. One investor asked me when he could look forward to getting those 4% high-quality muni bonds. I think if what the Fed is trying to do works, that’s not likely. We probably won’t see those kind of yields that high anytime soon, because higher yields usually go along with inflation. But we should be seeing better yields going forward as the Fed hikes rates.
MIKE: OK, so that’s the impact on individuals. Let’s talk about companies. At what point do companies begin slowing their spending?
KATHY: Well, it’s usually the case that companies will slow spending when the cost of borrowing rises enough to reduce the returns they can expect to earn on the money they’re borrowing. So, for example, say a company needs a new delivery truck, but the cost of borrowing to buy the truck is close to or higher than the money it can earn by using the truck, it probably won’t buy it, or it might buy fewer trucks in a given year because it just isn’t as profitable. It’s the same for large companies investing in software or services. If the expected return isn’t keeping up with the rising cost, it may not make sense to borrow.
MIKE: What about companies who don’t have positive cash flow, who have been borrowing heavily just to keep things running? How likely are we to start seeing companies fail as the cost of borrowing goes up?
KATHY: Well, those types of companies are going to end up with real problems. When interest rates are low, as they have been, and there are a lot of banks or investors willing to take chances, then many of these companies can borrow quite freely at very low rates. But when rates start to rise, they may not be able to service the debt, or make those interest payments. Also, oftentimes, investors are less willing to take risk on those types of companies when they can get a decent yield on bonds issued by safer companies. So that could be a negative for the negative cash flow companies, for sure.
MIKE: What about local governments? Doesn’t this environment also hurt local governments who have projects that they want to finance by issuing bonds?
KATHY: Well, local governments are a little different, in that their investments are very long-term and based on the needs of a community rather than expected profit. It might be, say, to repair a bridge or repave a road, so it’s safer. Maybe it’s building a community center. Those investments are less about the profit and more about infrastructure of the area that they’re trying to improve. So the local government will often issue bonds for that specific purpose, but it will need to know that its tax revenues can cover the interest payments on the bonds. In that way, if interest rates move higher, some public works may not get done because the local government simply can’t afford it.
MIKE: Well, one of the big developments in Washington last fall was Congress passing the infrastructure bill. That’s about a trillion dollars coming online over the next few years for projects just like what you’re talking about—roads and bridges and railways and airports, etc. But in most cases, that money is only a part of the cost of a project in a local community, and those municipalities will need to issue bonds to finance the rest of the project. So does that become harder now?
KATHY: It doesn’t necessarily become harder, but it does become more expensive. There’s a lot of demand for municipal bonds to fund these projects because they tend to generate pretty steady cash flows. So although it may mean the municipality pays a bit more in interest, and that makes it more expensive, it’s not likely to be an impediment to getting it done.
MIKE: Well, we’ve talked a little bit about the different kinds of impacts on different parts of the economy, but I want to dig in with you on the timing for what rate hikes are actually trying to accomplish. How long will it take for rate increases to actually have an impact on the high inflation rate? And since we all know that what the Fed does is an art, not a science, how will the Fed know whether to speed up or slow down that process so that, ultimately, they get to the Goldilocks outcome, not too much, not too little, but just right? What signs is the Fed watching for?
KATHY: Ah, the $64,000 question. Look, nobody knows for sure exactly how it will play out. We do expect inflation will fall somewhat, even if the Fed does nothing. That’s because supply and demand are starting to come into better balance. Business inventories are picking up, the pace of spending is cooling off a bit. Also, some of the extra money consumers got from the various pandemic-related stimulus plans is ending. So there won’t be as much extra money to chase the goods that are available. And, finally, just the math of how inflation is calculated will make a difference in the second half of this year. We look at the year-to-year change in the price of various goods and services to measure inflation. During the early part of last year—it’s hard to remember, it seems a long time ago—but the pandemic was holding back spending, so prices were actually falling on some things. Now that spending has picked up, any price increase is magnified by comparing it to a price drop last year. Now that’ll change in the spring when those price declines fall out of the equation. So, consequently, we think that the Fed may not have to move rates up as much as some people expect.
We look for the Fed to start raising rates, the fed funds rate, by 25 basis points this month, and continue until they get to maybe 1, 1¼%. And at that point, signs of slowing in the economy and inflation are likely to emerge, especially if the Fed also drains liquidity from the financial system by reducing its bond holdings. A wildcard, of course, is the cost of energy, and now food, particularly grains, due to the Russia-Ukraine conflict. If Russia ends up cutting off a substantial amount of natural gas flowing to the market, then energy prices could really rise further, and that could mean that the Fed has to hike rates more to slow the inflation. But as you say, it’s an art. The Fed will only know when it starts to see the pace of, say, spending and sales slow and inventories rise. It’s also likely that the unemployment rate will begin to rise as companies slow down hiring and production as the economy slows down. But given the higher starting level for inflation, the risk is that the Fed overdoes it and sends us into a recession. The number of times the Fed has been able to pull off a soft landing is pretty small.
MIKE: Kathy, I want to pick up on something you mentioned in passing a moment ago, and that’s the fact that the Fed also has an enormous balance sheet that it is trying to unwind. So it feels like the Fed is trying to do two things at the same time. How will that work, and how does the Fed expect that to help with bringing down inflation?
KATHY: Well, Mike, if you think of inflation as too much money chasing too few goods, then the Fed reducing its balance sheet is a means of lowering the amount of money that’s circulating in the financial system. Now, to be honest, nobody really knows how quantitative easing and quantitative tightening work in a precise way, but the idea is by buying up bonds and holding them, the Fed reduced the amount of bonds available in the market, sending down yields, and that pushed people into spending or investing in riskier assets, because they got so little return on their fixed income investments. Quantitative tightening is just the opposite. It takes those excess reserves or that excess money out of the banking system, which makes banks less able to fuel growth and to lend.
But quantitative easing and quantitative tightening are relatively recent innovations of the Fed, and we don’t have a precise way to measure the impact. A rough rule of thumb is that by reducing the balance sheet by around 400 to 500 billion has a similar impact as raising the fed funds rate by 25 basis points. Now, conceivably, the Fed could reduce the balance sheet by a trillion to a trillion and a half pretty quickly over the next 18 months, so that could substitute for some rate hikes.
MIKE: Well, Kathy, we’ve talked a lot today about the Fed and a rising interest rate environment and all that could mean for investors and the markets. But I think the thing on everyone’s minds is how all of this interconnects with what’s going on in the Ukraine. So to wrap up today’s conversation, do you think the Russia-Ukraine war could exacerbate inflation here in the United States, and how do you think the situation could affect the Fed’s game plan?
KATHY: Well, the war really complicates things. It has so many dimensions and unknowns. Some of what is being done hasn’t been done before, like the targeted sanctions on Russia. We’ve had sanctions before, but, frankly, isolating a country like North Korea is very different than trying to isolate a country like Russia, particularly from the entire financial system. So, yes, in the near term, the war could make inflation worse because oil prices are rising, but, eventually, if prices rise too much, consumers and businesses have to slow their spending, and that can lead to an economic slowdown or even a recession.
The other complication is that one of the Fed’s primary jobs is to make sure that the global financial system is functioning properly. It’s pretty much the central bank to the world when a crisis hits. In this case, if there are problems in banks that have relationships with Russia, and there are quite a few in Europe, or investors just get spooked and run for safety, then the Fed will likely have to open the money spigots and lend to foreign central banks so they can support their banking systems and their economies. Now that’s just the opposite of what they’re trying to do by tightening policy.
In my view, it’s hard to see how they can ease liquidity in the global financial system while simultaneously tightening policy at home. So, you know, in my opinion, it’s a possibility the Fed could hold off on a rate hike for a while, although that’s certainly not the consensus, but it is something that could happen.
MIKE: Well, Kathy, we’re certainly entering into a tense period of decision-making for the Fed, so I really want to thank you very much for taking the time to help us understand what it means for investors.
KATHY: My pleasure, Mike.
MIKE: That’s Kathy Jones. She’s a must-follow on Twitter @KathyJones, where you can find her take on everything that goes on at the Fed and in the fixed income markets, in general.
Finally, on my Why It Matters segment, I like to note something interesting that is happening in Washington that may have been below the radar screen and explain why I think it’s important.
Today, a quick update on taxes. Just six months ago, talk about tax increases dominated Washington, as what was then known as the Build Back Better Act included a new surtax on the wealthiest filers, some changes to the taxation of retirement savings, and more. Of course, none of that came to pass when the Build Back Better Act collapsed in the Senate in December, and 2022 began without any new taxes at all.
While the Build Back Better Act may be dead—and the relatively brief passing mention of it in the president’s State of the Union address underscored that—one of its key tax provisions is still very much on the minds of some members of Congress. That’s the state and local tax deduction, often known by its acronym—the SALT deduction. The deduction was capped at $10,000 in 2017, a change that has disproportionately impacted residents of high-tax states like California, Illinois, Massachusetts, New Jersey, and New York. Lawmakers representing those states worked hard to get the cap raised to $80,000 in the version of the Build Back Better Act that passed the House in November. But with the failure of that legislation, proponents of a higher cap are back to square one.
Last month, two Democrats in the House took a new approach, introducing legislation that would eliminate the cap for anyone making less than $400,000 a year. For wealthier filers, it would raise the deduction cap to $60,000 a year for filers above $400,000 in income and then reduce it by $10,000 for each additional $100,000 in income, until it is phased out completely for people earning $1 million or more.
This approach is trying to navigate a fine line. The states most significantly affected by the $10,000 cap are blue states, represented in Congress mostly by Democrats, and the people impacted by the cap are mostly wealthier residents of those states. These Democrats want to do something to help an important constituency in their state. But at the same time, Democrats generally have been advocating for increased taxes on wealthier filers as a way to pay for spending priorities. And those two goals are at odds with one another. So the phase-out approach to the SALT deduction is trying to split the difference.
I don’t expect the new SALT deduction proposal to move forward without a larger package that combines tax increases with spending on some of the president’s domestic priorities, like climate change and social programs. Right now at least, an agreement on that kind of spending seems very far away. But clearly some Democrats are going to continue to make this SALT tax deduction a priority in the weeks and months ahead.
Well, that’s all for this week’s episode of WashingtonWise. We’ll be back with a new episode in two weeks, so please take a moment now to follow the show in your listening app so you don’t miss an episode. And if you like what you’ve heard, leave us a rating or a review—those really helps new listeners discover the show.
For important disclosures, see the show notes or schwab.com/washingtonwise, where you can also find a transcript.
I’m Mike Townsend, and this has been WashingtonWise, a podcast for investors. Wherever you are, stay safe, stay healthy, and keep investing wisely.