The Federal Reserve is always between a rock and a hard place. That's the nature of its job.
On one hand, it needs to keep inflation in check to protect the value of the U.S. dollar. On the other hand, it can't let the economy cool down to the extent that unemployment gets to be a problem. But today, the Fed finds itself in an even tighter squeeze than normal.
Signs are pointing toward a stronger U.S. economy. After rising for nine consective months, March retail sales hit an all-time high. The economy has added jobs every month for the past six months. Manufacturing activity has expanded for 20 straight months.
The Fed should get some credit for the improving economy. It's kept interest rates near zero and has instituted a policy of quantitative easing, buying U.S. Treasuries to ensure rates stay low. [InvestingAnswers Feature: What is Quantitative Easing and Will It Save the Economy?]
But at some point the cheap money party has to end. And the question is: When is the Fed going to take away the punch bowl? And then what happens to investors?
As we all know by now, commodity prices have been steadily rising. Inflation has begun to be a problem for many of the world's economies. And the U.S. is now one of the only countries that hasn't raised interest rates since the financial crisis. Even the European Central Bank (ECB) raised its main interest rate a couple of weeks ago. The central bank felt it needed to raise rates now to combat rising inflation despite the fact that some of its weaker European Union members are still struggling with debt problems and sluggish economies.
The central banks of Russia, China, India, Brazil, Peru, Chile, Poland, Thailand, Serbia, Vietnam, Colombia, Nigeria, South Korea -- and more -- have also raised their interest rates.
So why doesn't the U.S. Federal Reserve pull the trigger?
First, we're struggling with persistently high unemployment. Higher interest rates mean higher borrowing costs for companies and consumers, and an increase in rates will likely slow the economy. Second, even though the job picture is improving, unemployment is still problematic. Higher interest rates will push up mortgage costs, and housing is one sector that still needs all the help it can get.
The Fed is also getting ready for the fiscal tightening that's just around the corner. The writing is on the wall: U.S. federal budget cuts are coming. While Congress may spend a lot of time bickering about the details, trillions of dollars will eventually be slashed from the budget. (Just recently, Standard & Poor's cut its outlook on U.S. debt to 'negative' due to sky-high deficits.)
A more austere budget might be what we need in the long term, but it won't make things easier in the short term. For instance, England cut its government department budgets by 19% last October. In the fourth quarter of 2010, England actually saw its economy shrink. [InvestingAnswers Feature: U.S. Spenders vs. U.K. Savers: Who's Headed to Prosperity?]
Today, core inflation (the rate of inflation on goods and services, not including the volatile food and energy groups) is tame. This allows the Federal Reserve to maintain its policy of historically low interest rates. But if food and energy prices remain high, it won't take long before companies have to pass on costs to consumers, leading to an increase in the core inflation rate.
I imagine that all these considerations are keeping the Fed up at night.
So what should investors do in light of the Fed's conundrum?
The Fed is biding its time, which means investors have some time to enjoy low rates. But don't get too complacent in our low-interest world. Here are some of the things I'm thinking about now, just in case we actually start seeing higher inflation that will, in turn, necessitate higher interest rates.
1) I want my stock investments to be in companies with strong pricing power. I want companies that can pass off higher costs to consumers and maintain their profit margins. This means I want companies that have strong brands, defensive products and services, and/or products and services that are always in demand.
[Read our Practical Guide for Choosing Companies to determine which companies are strong enough to withstand higher inflation and interest rates.]
2) I want to be underweight in longer maturity, higher quality, fixed-income investments. As interest rates rise, these securities tend to experience more downward price pressure.
[Check out our article Don't Get Caught on the Wrong End of a Rate Hike for tips on investing during rising interest rates.]
3) I want to increase my holdings in shorter maturity or floating-rate income investments. That way, I won't be as exposed to the rising rates that make the aforementioned longer-term, lower-yielding investments less attractive.
[Read about adjustable rate funds in our article: 3 Simple Ways Everyone Can Hedge Against Inflation.]
4) I want to be overweight in countries that can afford their debt because their economies are growing. This includes countries like Brazil and Australia.
[See our article that lists and describes the fastest growing economies.]
With these simple moves, I'll be ready if rates start creeping higher. And if they don't, I'll still be in some of the most attractive investments in any market.
Photo courtesy of Michel Tronchetti
