New Fed Chairman Kevin Warsh Just Gave a Warning to Wall Street. Here's Why You Shouldn't Panic.
Interest rates are holding steady, but there's more to the story.
By Jennifer Saibil
After some drama at the Federal Reserve, economist Kevin Warsh was confirmed as chairman in May and chaired his first meeting last week. While the Fed's decision to keep interest rates steady was expected, Warsh's decline to provide guidance for the remainder of the year was new. In the past, the Fed has provided an outlook for the rest of the year.
Warsh has said that the guidance is meaningless in terms of what actually plays out, yet impacts markets in the short term, making them even worse than useless. The market was hoping to get some reassurance that the Federal Reserve would cut rates at some point, and without it, the market still took it as a future signal -- in this case, a negative one.
The S&P 500 (^GSPC 1.32%) dropped slightly on the news. However, investors shouldn't panic. Here's why.
Rates may not be coming down so soon
The market likes low interest rates. They stimulate the economy in multiple ways. When rates are low, businesses can borrow more and expand, and customers can borrow more to maker bigger purchases. There's more money in circulation, and investors feel good about the market and growth prospects.
The flip side of that is inflation. As more money enters the economy, it could become worth less. That's essentially what happened after the COVID-19 stimulus packages. Prior to that, interest rates were near zero to get the economy moving from pandemic stalls. The Fed may have overshot; the flow of money created the inflationary environment that still persists today.
The Federal Reserve had begun lowering interest rates as inflation was moderating, but it has soared again since the war with Iran. Its target is for inflation to stay around 2%, but it reached a three-year high of 4.2% in May. Warsh has said he is committed to stemming inflation, and that suggests interest rate hikes might be coming, rather than cuts.
Warsh himself declined to provide guidance, but other Fed officials provided a "dot-plot" signaling hikes later this year before coming down in 2027. Of course, that's the hopeful chart: slight hikes lead to lower inflation, which leads to rate cuts.
Keeping interest rates high curtails the amount of money in cycle and leads to lower economic activity. That makes it harder for companies to produce the kind of growth investors look for, leading to a loss of confidence in markets.
Why investors should stay calm
In a nutshell, that's how economic cycles work. The good news for investors is that historically, the economy has been in growth mode far more often than not. That's why over time, the stock market has been the ultimate wealth-building machine.
If the market eventually falls as interest rates rise and companies slow down, the worst thing you can do is sell your stocks. The market is likely to rebound and reach new heights, like it has every time in the past. It could take a while, so investors should maintain a long-term mindset. If the dot-plot is right, lower rates are on the way. Even if it's not, it should happen at some point.
If you have a well-diversified portfolio that includes safer stocks, and you plan to hold through volatility, you have no reason to panic.