Category: Interest Rates

Rising Rates: The Fed Takes Next Step Toward Normal

On December 14, the Federal Open Market Committee (FOMC) voted unanimously to raise the federal funds rate by 0.25% — to a range of 0.50% to 0.75%. This was the second increase since December 2008, when the benchmark rate was lowered to a near-zero level (0% to 0.25%) during the Great Recession.1

The rate hike was widely anticipated by investors, and the only element of surprise was a change in the forecast for the federal funds rate. The median projection for the end of 2017 is 1.4%, up from 1.1% in September, which suggests that Fed officials now expect three additional rate increases in 2017 instead of two.2

As the financial markets priced in the prospect of an extra rate hike, the yield on two-year Treasuries surged to its highest level since August 2009. The 10-year Treasury yield climbed to 2.523%, the highest level in more than two years and a full percentage point higher than the record low in early July 2016.3(Bond yields typically rise as prices fall.) The S&P 500 index declined 0.8% on the day of the Fed’s decision, but recovered quickly and rose 0.4% the following day.4-5

The December rate hike reflects the committee’s growing confidence in the health of the U.S. economy, but it’s also likely to push up borrowing costs for households and businesses.

Central Bank Influence

The Federal Reserve and the FOMC operate under a dual mandate to conduct monetary policies that foster maximum employment and price stability. The federal funds rate is the interest rate at which banks lend funds to each other overnight within the Federal Reserve system. It serves as a benchmark for many short-term rates set by banks.

Adjusting the federal funds rate is one way the central bank can influence short-term interest rates, economic growth, and inflation. The Fed has been tasked with loosening monetary policy early enough to keep inflation from flaring up, but not so quickly as to reverse economic progress or upset financial markets.

Second Time Around

A lot has happened since December 2015, when the stock market cheered the Fed’s first rate increase since the financial crisis. At the time, the Fed projected four rate hikes by the end of 2016, but tightening was put on hold when GDP growth and inflation were slow to materialize. A number of outside risks, including a weak global economy and uncertainty surrounding the June Brexit vote, threatened to dampen U.S. GDP growth in the first half of 2016.6

The Fed’s most recent statement acknowledged that “the labor market has continued to strengthen and that economic activity has been expanding at a moderate pace since midyear.”7 Unemployment fell to 4.6% in November, a nine-year low, and GDP growth improved to 3.2% in the third quarter.8-9

Inflation is still below the Fed’s 2% target but has started to firm in recent months. According to the Fed’s preferred measure, personal consumption expenditures (PCE), prices rose at a 1.4% annual rate through October, and core PCE (which excludes volatile food and energy prices) rose at a 1.7% rate.10

What About Investments?

When interest rates rise, the value of outstanding bonds typically falls. Longer-term bonds tend to fluctuate more than those with shorter maturities, because investors may be reluctant to tie up their money if they anticipate higher yields in the future. Bonds redeemed prior to maturity may be worth more or less than their original value, but if a bond is held to maturity, the owner suffers no loss of principal unless the issuer defaults.

Equities may also be affected by rising rates, though not as directly as bonds. Stock prices are closely tied to earnings growth, so many corporations stand to benefit from a more robust economy. On the other hand, companies that rely heavily on borrowing will likely face higher costs, which could affect their profits.

Considerations for Consumers

The prime rate, which commercial banks charge their best customers, is typically tied to the federal funds rate. Though actual rates can vary widely, small-business loans, adjustable rate mortgages, home equity lines of credit, auto loans, credit cards, and other forms of consumer credit are often linked to the prime rate, so the rates on these types of loans may increase with the federal funds rate. Fed rate hikes may also put some upward pressure on interest rates for new fixed rate home mortgages.

Although rising interest rates make it more expensive for consumers and businesses to borrow, retirees and others who seek income could eventually benefit from higher yields.

The FOMC expects economic conditions to “warrant only gradual increases,” but future Fed policies will depend on global financial developments, economic data, and growth projections. If inflation rises more or less than expected, rate adjustments will likely follow suit.

The financial markets could continue to react to Fed policies, but that doesn’t mean you should do the same. As always, it’s important to maintain a long-term perspective and make sound investment decisions based on your own financial goals, time horizon, and risk tolerance.

The return and principal value of stocks fluctuate with market conditions. Shares, when sold, may be worth more or less than their original cost.

1-2, 7) Federal Reserve, 2016
3-6) The Wall Street Journal, December 14-15, 2016
8) U.S. Bureau of Labor Statistics, 2016
9-10) U.S. Bureau of Economic Analysis, 2016


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How Interest Rate Hikes Affect Retirees

business-money-pink-coins-largeIn December, the Fed increased interest rates for the first time since mid-2006. We know that the realities of the 2008 financial crisis led the banking system to lower the rate to zero during its height, and remain there for nearly seven years as America’s economy recovered. During that time, however, savers have been on the short end of the stick. Retirees, especially, saw much lower returns and higher risks than imagined, causing discontent even with news of recovery and a thriving economy in the backdrop.

Now, as the Fed is expected to gradually increase rates in the coming months, claims of recovery appear more realistic than ever. First, one must understand that the Fed’s decision to hike up interest serve as a balance to consumer spending and aid in curbing inflation. By doing so, the bank increases the cost of capital, making it more expensive to get things like loans and purchase cars and similarly large items. As a result, the rate at which most people do so decreases, which may seem like the antithesis of how the economy should work, but it is effective.

Naturally, many have questions about just how effective it could be, and how higher interest directly affects their personal lifestyles. The answer is, it depends. As with most situations pertaining to finances, there are no absolutes; however, there are a few things retirees can expect as a result of this move which are promising.

  1. Better Returns for Savers:
    Saving makes more sense (and more cents) as interest rates climb. Investing in CDs over savings accounts typically generates more income at a fixed rate, depending on the terms. This wouldn’t be as significant in a near-zero interest situation, but with recent hikes, this is a smart financial decision with low-risk and more money for the future.  Shop around for the best deals or consult with your financial advisor for assistance.
  2. Increased Portfolio Options:
    Many have chosen to fill portfolios with stocks because of a greater chance for return. But in higher interest situations, bonds can be a great asset, and are less prone to risk than stocks. Now, that doesn’t mean that current bonds won’t be affected. Longer-dated bonds will lose value as yields and interest move in opposite directions. However, buying shorter maturities is a great defense, and a trend more people are moving toward.

    By that same measure, stocks can be beneficial for those who are more conservative. As I mentioned previously, the Fed’s actions are a sign that the economy is progressing in the right direction. Kira Brecht at U.S. News suggests that
    sectors like banking, energy, and technology are the best options in this type of situation. It’s worth consideration.

  3. More Money From Annuities:
    Annuities have been steadily declining due to low interest rates. According to the Secure Retirement Institute, sales fell 5% in the first half of 2015, in comparison to the year prior. To put that in perspective, sales rose more than 10% in 2006 but only a paltry 3.8% in 2014. However, that could change. Fixed rate annuities could provide a steady source of income and security in the event that rates drop again. Purchasing from different companies at different times provides an extra cushion in that all of your eggs won’t be in a basket that could be shattered should a company collapse or fall victim to bankruptcy.

Despite these benefits, one could experience adverse effects of hikes in other areas. Credit card users and those considering refinancing their homes may not have much reason to smile. However, gradual shifts provide a time to plan and strategize in ways that make the most sense for your future. If you haven’t already, you should start thinking about how to take advantage of the benefits of this once in a decade moment.