The Federal Reserve Bank (Fed) implements monetary policy that has a broad impact on the US economy. One of the ways the Fed impacts its dual mandate of managing unemployment and inflation is to periodically raise or lower interest rates.
The Federal Reserve in November 2022 raised interest rates by three-quarters of a percentage point — or 75 basis points — for the fourth time in the calendar year, bringing its key benchmark borrowing rate that rules all other interest rates in the economy up to a target range of 3.75-5 percent, where it hasn’t been since early 2008, according to a Bankrate.
The fed funds rate matters because it has ripple effects on every aspect of consumers’ financial lives, from how much they’re charged to borrow to how much they earn in interest when they save. And, changing interest rates is one of the main tools that the Fed can use to cool down inflation.
Inflation is the increase in the prices of goods and services over time and occurs when the demand for those goods and services exceeds supply. Inflation also represents a loss of purchasing power.
Typically, the Fed raises interest rates in times of economic expansion and does so to prevent the economy from overheating. The opposite is true when interest rates are cut, which typically occurs when the economy is in a down trend.
To raise interest rates, the Fed changes the overnight rates at which it lends money to banks. That sets off a chain reaction that impacts the rates banks charge to businesses and individuals. When rates rise, the impact on the economy includes:
- Borrowing costs rise for businesses, which can reduce investments in new plants, equipment, marketing, and physical expansion.
- Borrowing costs rise for consumers, which reduces consumer spending, home buying, and investing.
- Savings accounts and other low-risk investments earn more interest, making investing in low-risk instruments more attractive.
Markets adjust, with fixed income securities generally reducing in value and equities reacting in a mixed fashion depending on how much a rate rise is expected to affect specific types of businesses.
The U.S. Interest Rate Historical Timeline
The chart below shows the history of Fed Funds Rates going back to 1954.
Chart of Fed Funds Rate (Macrotrends)
Rising interest rates impact investing in several ways, some of which are fundamental and some of which are perceptual.
Adding to the dilemma for many investors is the inflation outlook and the question of how transitory or persistent that inflation will be. From a rate perspective alone, rising rates can be expected to have the following impact:
- Prices of bonds and other fixed-income investments will weaken with rising rates, especially the longer-term instruments.
- Rates offered on new bonds will rise, making them somewhat more competitive with equities.
- Rates should rise in bank products such as CDs, bringing them back on the radar for investors.
- When rates rise, stocks tend to fall — when rates fall, stocks rise.
Equity market reactions will be mixed, depending on the effects of higher rates on different companies and industries. Companies that are more leveraged will incur higher costs. Companies with high-ticket products that rely on consumer credit may weaken. On the whole, rising rates should also dampen enthusiasm to speculate, given higher borrowing costs.
“When interest rates are low, companies can assume debt at a low cost, which they may use to add team members or expand into new ventures,” says Brenton Harrison, CFP® professional based in Nashville, TN. “When rates rise, it’s harder for companies to borrow and more costly to manage what debt they already have, which impacts their ability to grow,” he adds. These higher costs may result in lower revenues, thus negatively impacting the value of the company.
Also keep in mind that as rates fall on savings accounts and certificates of deposit, investors generally seek out higher paying investments like stocks and are generally seen as a catalyst for growth in the market; in a rising rate environment investors tend to shift away from stock to places with less risk and safer returns.
The specter of rising rates can also change the behavior of investors, many of whom may decide to put off purchases on credit or sell stocks that were purchased on margin, based more on their expectations than on near-term reality.
“Central banks tend to focus on fighting the last war,” says Scott Sumner, monetary policy chair at George Mason University’s Mercatus Center. “If you have a lot of inflation, you get a more hawkish stance. If you’ve undershot your inflation target, then the Fed thinks, ‘Well, maybe we should’ve been more expansionary.’”
References:
- https://seekingalpha.com/article/4503025-federal-reserve-interest-rate-history
- https://www.bankrate.com/banking/federal-reserve/history-of-federal-funds-rate/
- https://www.businessinsider.com/personal-finance/how-do-interest-rates-affect-the-stock-market