Investing

Why is the Fed Increasing Rates?

At last week’s FOMC meeting, the Federal Reserve raised the benchmark lending rate by 0.25%, marking the first rate increase since 2018 — and indicated that more rate hikes are on the horizon in 2022. So, why did the Fed decide to raise rates, and what impact could this have on you, as an investor and a consumer?

The History of Monetary Policy & Interest Rates

The Fed’s official mandate is to conduct monetary policy “so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” This helps support conditions for long-term economic growth. The Fed has traditionally used three main tools to conduct monetary policy which are (1) open market operations, (2) the discount rate, and (3) reserve requirements.

The Federal Reserve’s policy approach has evolved considerably since the financial crisis and many more tools have been added. Though the way the Fed raises and lowers interest rates has changed in recent years, the premise remains the same. When times are good, the Fed typically raises rates to keep a lid on inflation. When times are tough, the Fed may lower rates to encourage lending and economic activity.

For the Fed, it is a balancing act of not raising interest rates too fast (which could push the economy into a recession) or too slowly (which risks losing control of inflation.) Policy mistakes are always a risk, but one positive development has been an increase in transparency by policy makers around the decisions being made.

Interest rate adjustments by the Fed flow through to the economy, impacting borrowing and saving. Having a basic understanding of what this means for you can help you make better financial decisions.

The Impact on Mortgages and Credit

With the Fed signaling plans for several rate hikes this year, the bond market has preemptively been pricing in these expectations. The 10 year treasury yield, which is often a benchmark yield for mortgage rates, has moved higher and mortgage rates have followed suit. A typical 30-year fixed mortgage is now – for the first time since 2019 – over 4%.

Ultra low interest rates over the past decade or so have contributed to a huge boom in the housing market. Typically when rates go up, it becomes more expensive to borrow, which then reduces the demand for housing ultimately causing a slowdown in the housing market. Just like the stock market, trying to time the housing market or interest rates is a fool’s errand. But it is important to understand the dynamics of mortgage rates and housing prices if you are considering a home purchase. For those that are already locked into a fixed rate mortgage and planning to stay in their home long-term, this is less of a concern. For those looking to purchase a home, this increase in borrowing cost needs to be taken into consideration.

If you are carrying revolving credit card debt, higher rates are bad news because your bank is likely to be slow to pass on higher yields on your checking and savings accounts. However, they likely won’t hesitate to charge higher interest rates on debt. Paying down or eliminating credit card debt should always be a priority when it comes to your finances, but it is even more important when rates are rising.

See the impact of debt on your net worth by using Personal Capital’s free financial tools.

The Impact on Bond Holdings and Stock

Most investors are aware of the inverse relationship between interest rates and bonds. When rates are expected to go up, the price of existing bonds drops since the fixed interest rate they pay will be less attractive than newly issued bonds offering a higher interest rate. This dynamic causes some to question: why own bonds at all when rates are going up? For one, it’s not quite that simple. Bond prices move well before actual rate increases, and there can be overshoots (2013 Taper Tantrum,) or the economic environment can quickly change (as we saw in 2020). We’re seeing this happen now. The federal funds rate – the rate the Fed controls and subsequently influences other rates – is still near zero, but the bond market has already priced in all the expected rate hikes for 2022.

Longer-term rates are even harder to predict and long-term bonds tend to come with more interest rate risk due to their higher duration. Bond duration is a measure of interest rate risk and can provide a gauge of the expected price change of a bond for a 1% change in interest rates. In a rising rate environment, it is especially important to manage the duration of your bond allocation, but there are also still good reasons to own bonds in your portfolio.

Most importantly, bonds provide stability in a portfolio and can help reduce portfolio risk without sacrificing too much return potential. With inflation high, it’s still better than holding cash, and bonds are not as risky as often perceived. Some may only be considering the price drop and forget to factor in the income in returns. Others fail to keep perspective that losses in bonds tend to be much less than losses in stocks, and have lower historical volatility.

For stocks, higher rates mean safer alternatives become more attractive. This can put pricing pressure on stocks, but this alone does not prevent stocks from moving higher. Historically, stocks tend to fare well for some time after initial rate hikes, with more mixed results typically starting to surface a year or more later. In a rising rate world, companies trading at higher valuations are at greater risk because future earnings become less valuable now. Owning a mix of both growth and value stocks can help balance this risk.

U.S. stocks continue to trade at a premium to international stocks, so global diversification is also important. Alternatives can also be a great way to increase the diversification of a traditional stock and bond portfolio, especially during rising rates and inflation. Of course, there are always many factors at play simultaneously, and interest rates are just one of them. We believe that owning a globally diversified multi-asset class portfolio is the best way to manage portfolio risk, whether the source be interest rates, inflation, or other types of portfolio risk.

What Higher Interest Rates Mean for You

Higher rates bring opportunities and risks. We urge our clients to stay focused on long-term goals and stick with strategies that are proven to work over time. We advise against getting too caught up in extrapolating what future rate hikes may occur and what the implications may be, and instead focusing on implementing a holistic financial plan.

Learn more about how we give guidance to clients of Personal Capital by visiting our Wealth Management page.

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