The big news of last week was the increase in the federal funds rate to a target range of 1.5 to 1.75 percent. This is an increase of 25 basis points (a quarter of one percent) from the prior level, established in December 2017. There are direct and indirect consequences of the change in rate. Whether or not you need to take any action will be a function of your present situation.
What Is the Federal Funds Rate?
The Federal Reserve exerts influence on the economy through monetary policy. No mechanism has greater economic influence, nor is as closely watched, as the federal funds rate. This is the rate that banks pay to borrow from other banks’ balances held at the Federal Reserve. Banks borrow from one another’s balances at the Reserve to meet their specific financial requirements. By manipulating the rate that the Federal Reserve pays banks on their deposits, the Fed has a nearly direct influence on what banks charge to borrow from one another’s balances held at the reserve.
There is really no reason for a bank to loan funds at a rate lower than the one that the Federal Reserve pays on balances that it holds. That would result in a loss of money. Nor is there a reason for a bank to pay a much higher rate than what the Fed pays on funds in order to borrow funds held at the Reserve, as there are currently ample funds available. So while the rate it pays on deposits is not the same as the federal funds rate, the Fed can steer the federal funds rate to its desired target by manipulating the rate it pays on these deposits.
Since the economic crash of 2008, the Federal Reserve has been primarily concerned with economic stimulation. Now the bank seems to have returned to a more traditional approach to influencing economic activity. And as had been the case for a number of years prior to the crash, inflation has again become a major factor. The Fed applies brakes to the economy by manipulating interest rates to increase the cost of borrowing. Increasing the cost of capital reduces the rate of economic growth and the inflationary pressures associated with rapid growth.
Beyond the Rates
This is the sixth increase by the Fed since December 2015. Each one has been the same amount: 25 basis points. This one, however, may be more significant than these prior increases.
In addition to the rate itself and the implications coming from that change, the Fed also issues commentary, which provides a window on the bank’s current thinking about future plans. These plans include ongoing rate changes. That may very well be the more important factor for many people.
Looking at Where We Are
We remain in a very low-interest-rate environment. Many of us have gotten so used to hearing about “historically low interest rates” that it now seems like an everyday expression.
Mortgage rates in particular seem unable to escape this label, and they are not likely to do so in the short term. After all, a quarter of a point rise is not a significant change. But the smart money looks to the horizon.
Perhaps you are one of the many who failed to notice the last five increases that the Fed made. So far, the consequences have been minor. But we should look more deeply at how, roughly speaking, events play out.
When the Fed raises rates, there are some immediate changes. Banks charge one another more in order to borrow overnight. They also immediately begin to charge more in other areas. This affects variable rates that change quickly. If you have a variable mortgage that changes once a year, it naturally won’t change immediately. But there are a number of changes that are just a small step away.
The interest rates on treasury bills, commercial paper, and other short-term debt tend to closely follow the federal funds rate. Longer-term debt is less directly influenced, as there are more and larger economic factors across longer time periods.
But short-term debt is heavily influenced by the federal funds rate.
The cost of government borrowing rises; the cost of banks borrowing from one another rises; and the cost of businesses borrowing by way of commercial paper rises. These near-term effects happen quite quickly.
Then consumers are directly affected in several fashions. Many credit cards are indexed off the prime rate. The prime rate is the lowest rate available for commercial borrowers, hence an increase in rates that banks charge commercial customers swiftly leads to an increase in the rate charged by many credit cards. Note that this doesn’t have an impact on all cards. Not all credit cards are indexed off rates, and others may be indexed off a rate other than the prime rate and may move up more slowly.
Fixed rates will also tend to rise for new loans. There will be small increases in the cost of car loans and mortgages. The rates remain incredibly low, and the minor increase will barely be noticeable to consumers. A typical $20,000 five-year car loan will go up by two dollars and change per month. A $100,000 thirty-year mortgage will rise by about $15 a month with the full impact of a quarter-point rate increase. Hopefully that won’t change anyone’s ability to buy a home. Interest rates really are very low — money remains on sale.
Asset values are also affected by interest rates. Equities compete to be purchased, so an increase in interest rates changes their competitive positioning versus other asset classes and also increases the cost of capital to purchase on margin. The markets expected this increase, and it was well priced in; there is nothing to gain and no new opportunity.
Interest rates have an impact on bonds, as well. Increasing rates decreases the value of existing bonds, with longer times to maturity being affected to a greater extent due to the longer time differential. Of course, even bonds that end up selling below their face value return to face at maturity. If you’re holding bonds strictly for interest earnings, as many retired people do, the minor fluctuations in principal due to a small change in rate isn’t important.
The impact of future increases is more of a concern for many bond holders. While the Fed says that we have a few more increases coming, we need to think longer term and expect even more increases. Holding bonds as a significant portion of a long-term accumulation strategy may involve greater interest rate risk than investors realize. It may be best to view long-term bonds as worth their coupon at best — and that with a bit of a potential downside.
What Should You Do Now?
Remember, smart money looks to the horizon. Last week’s increase is fairly insignificant by itself, and changes are better done before the fact than after. But more is coming. That is what to plan for and act on. Here is what to be aware of:
Credit card interest rates will increase for many accounts in this rising-interest-rate environment. Credit card interest is painful for many people now. Pay down credit cards as fast as reasonably possible, because they are going to cost you even more going forward. Avoid using credit cards for purchases that you’ll end up paying interest on. There are far cheaper ways to borrow money if you need to.
Mortgage rates will also tend to follow the increase in an upward direction. In the short-term this increase probably won’t cause many people to miss out on the house of their dreams. However, a few increases in combination have a much larger affect. If you are considering buying a house, be very conscious of your timing. Unnecessary delay will most likely lead to higher borrowing costs. Of course, no one gets ahead by making bad or rash decisions. Think things through, analyzing carefully. If the time is right, act. It is better to wait and get less than you want and be able to afford it than it is to leap into something you cannot afford.
While stock prices incorporated the rate increase before it happened, there may still be factors to consider. For example, if you have assets on margin, you should know how the interest rate on that account is determined so you can evaluate and plan going forward. Don’t be surprised if, a couple of rate hikes down the road, your margin costs have risen considerably.
Be cautious with bonds. There are several ways to mitigate interest rate risk. If you invest in bond mutual funds or exchange-traded funds (ETFs), you should consider the fund’s interest rate risk. For individual bond holdings, also consider the potential effect of rising rates. You don’t necessarily need to sell; there is no reason to panic. For many individual bondholders, a decrease in principal value is nothing more than a nuisance, as they care only about receiving the interest. But if you are trying to build capital, you may need to consider alternatives or reducing your interest rate exposure.
The Bottom Line
For most people, the Federal Reserve’s action requires no reaction other than a good yawn. Money behaves in a fairly predictable fashion when considered from a long-term perspective. In the short term, things can get wild. In the long term, not near so much. Look at what may cost you more, what you may want to act on while rates remain low, and how future increases may have an impact on your investment portfolio. There’s no rush right now, but when there is a rush, it will be too late.
The opinions expressed in this article are those of the author alone and do not necessarily reflect the official policy or views of CentSai Inc.