Mon, Sep 26, 2022 12:01 PM
By Rebecca Holcomb, Wealth of Geeks
As if a steady 8.54% inflation rate wasn't bad enough, in late August, the Federal Reserve, known commonly as the Fed, issues an ominous statement.
The Fed is responsible for raising and lowering interest rates and controlling inflation so that it doesn't get out of hand.
"While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain," explained Fed Chair Jerome Powell.
Prior to the Fed's announcement, Scot Johnson, a certified financial advisor with Wealthtender and Chief Investment Officer at Adell, Harriman and Carpenter, Inc., predicted an increase. "Fed officials have flat out said they will raise their policy rate in September, but they haven't specified the size of that move."
Powell's promises to control inflation speak to the Fed's determination to help curb rising prices before it becomes hyperinflation - a period of accelerating inflation.
When the US Dollar was taken off the gold standard completely in 1971 by then President Richard Nixon, it allowed for free-floating fiat currencies. And so started the massive debt-based system the US relies on today.
To further complicate things, dollars that are traded between countries that purchase and sell oil are called Petrodollars. They shield the United States from the consequences of debt.
What Are Petrodollars?
Let's say the US buys oil from Saudi Arabia. Saudi Arabia pays US corporations in petrodollars for services and technology to extract the oil. The US then lends those petrodollars to emerging markets, raising the global demand for oil.
The higher demand forces other countries to buy oil from Saudi Arabia. Saudi Arabia puts their excess petrodollars into sovereign wealth funds that invest in non-petroleum assets like US Treasuries, pushing up the price of the dollar.
This revolving petrodollar infusion means the US can spend incredible amounts of fiat currency - without needing to pay it back anytime in the near future. Those Saudi petrodollars are essentially forced treasury buys, infusing the US economy with ‘free' currency.
But all good things come to an end. It sounds like a benefit for the US dollar to be at its strongest point in 20 years, but it's detrimental for US corporations that do business overseas and most other economies.
Strong Dollar Is Bad News
Any US corporation that does business overseas is going to lose serious revenue as a strong dollar pushes down other fiat currencies.
Take India's rupee. Its value against the US dollar is 79.46. If a corporation sells a service for 10,000 rupees, its US net profit would only be $125.85. But what if their product is valued at $500? See the incredible loss they'd suffer?
A strong dollar is also bad for emerging and established economies. When the US dollar is strong, other currencies can't keep pace, and citizens have to spend more of their country's currency to manage items bought and paid for in US dollar currency. So a moderate paycheck for someone in a different country now becomes worth less and less as the dollar strengthens.
Fed Warning Too Little Too Late
Last week, the Fed made the move to increase policy interest rates by 3/4 of a percentage point to 3.25 percent, effective September 22, 2022.
While higher interest rates are great for those who are putting their dollars into savings and bonds accounts, things are still stark for the rest of the economy. Ayad Amary, a certified financial planner with Wealth Care LV and a Wealthtender financial advisor, had this to say about the potential impact of higher interest rates.
"One of the biggest, yet least talked about risks of rising interest rates is the impact it will have on companies that are operating with negative cash flow. Many investors may not realize that an estimated 30-40% of publicly traded companies operate at a loss. This is significant because it means they are dependent on issuing debt to run their operations. As interest rates rise, so does the cost of borrowing money.
"…these companies will eventually need to issue debt at higher rates, thereby adding more risk to an already challenging economic environment. If you are investing in individual stocks, it is imperative that you take a close look at the company's free cash flow and other financial metrics to determine if they can withstand such pressures."
"For the average consumer, higher Fed rates mean higher minimum payments and more compound interest on your revolving debt balances. Home Equity Lines of Credit (HELOCs) and credit card balances will be directly impacted, and in turn, so will your cash flow. From a planning perspective, this may change the priority of your resource allocation. In other words, it may change the order in which you use your monthly cash flow.
"Perhaps in the past, you were investing more into your 401k or brokerage account because the interest rate on your HELOC was very low. If you have revolving debt on your balance sheet, it may be worth discussing with your advisor if you need to shift strategy, considering we are now entrenched in a rising interest rate cycle. "
The impact on the average American citizen can vary widely depending on the level of debt and interest rate type each person holds, but one thing is clear. Higher interest rates mean higher payments, and varying rate debt is the worst kind to have when interest rates go up.
‘More pain' as the Fed chairman calls it, has been going on for some time now, and with no end in sight, most are preparing for a ‘worse before it gets better' scenario if it ever does.
At the press conference last week, Chair Powell explained, "…we anticipate that ongoing increases will be appropriate… In terms of reducing rates, I think we'd want to be very confident that inflation is moving back down to 2 percent before we would consider that. We're committed to getting inflation back down to 2 percent because we think that a failure to restore price stability would mean far greater pain later on."
For consumers, it might be time to plan for things to get worse before they get better.
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This article was produced and syndicated by Wealth of Geeks.