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As the Federal Reserve weighs its options for interest rates, investors are bracing themselves for a long and tumultuous ride. The prospect of a rate hike has raised concerns among investors and consumers alike, as the effects of monetary policy are both structural and psychological.
In a recent tweet storm, @coloradotravis highlighted the challenges posed by the long and variable lags associated with the implementation of monetary policy. Although rate hikes do mechanically change the value of collateral and the price of capital, it takes time for these changes to impact aggregate decision-making.
While the “rational” response to an increase in the cost of credit would be to use less of it, there are situations where people may initially use more of it, particularly if they have limited options or do not plan well. This can lead to a burst of speed before the structural response kicks in, resulting in a potential credit crunch.
Consumers are already charging up their credit cards and businesses are delaying cost-cutting due to recency bias, but the Fed is not expected to flinch as it did in the past. The quick rebound in 2020 was due to the Fed backstopping private credit markets that were facing a structural meltdown. This time around, the Fed may not be able to engineer a swift bounce back, even if it wanted to.
The legality of the mechanism that causes a rebound was altered by the CARES Act, so the Fed simply can’t manipulate the market as it did in the past. As a result, investors are bracing themselves for a potential downturn, with the curve historically inverted.
According to Ebony Rose, a financial analyst, the memories of the 2008 recession and the 10% unemployment in 2010, a year after the recession technically ended, are still fresh in people’s minds. The road ahead is likely to be long and bumpy, and investors need to be prepared for potential market volatility.
As the Fed weighs its options, investors should remain vigilant and stay diversified to protect their portfolios from potential downturns. While the future is uncertain, investors can take steps to manage their risk and prepare for potential changes in the market.
