While the era of cheap money is far from over, the Federal Reserve’s decision to lift higher interest rates in December was a paradigm shift for a nation that has struggled to regain its footing since the 2008 financial crisis. The rate hike, which was the first in nearly a decade, is a sign that policymakers are finally convinced the US economy is strong enough to handle tighter monetary policy. Although a rate adjustment of 25 basis points is unlikely have a big effect on the markets, the four additional rate hikes anticipated this year certainly will. One financial analyst likened the Fed’s tightening schedule to the progression of the winter season.
“The first dusting of snow isn’t what cancels school and ties up traffic but does signify the beginning of winter – that’s really where we are.”
Why did the Fed raise rates in December?
There are several reasons why the Fed embarked on a rate hike in December. The first largely has to do with the Fed’s mandate of promoting economic growth and price stability. The US economy has witnessed its longest hiring spurt in history, helping to push unemployment to a 7 ½ year low. Fed officials clearly believe that a strong jobs market will ultimately spur a pickup in inflation and wages, which have struggled to keep pace with the surging jobs market. As a result, raising the cost of borrowing is seen as a prudent way to keep inflation in-line once the impact of weak oil prices subsides.
It can also be argued that the Fed raised interest rates partly in response to growing pressures from the global financial markets, which have been pricing in a rate adjustment for a long time. Additionally, officials have repeatedly claimed that they wish to raise rates gradually over several years. By starting the process now, it is argued, the Fed has plenty of time to lift borrowing costs gradually without making sudden moves down the line that could disrupt the financial system.
What does a rate rise mean for US consumers?
The real question isn’t what a single rate hike means for consumers and households, but what the cumulative effect of multiple rate hikes will be over the next couple of years.
Home-buying: Multiple rate increases will mean higher adjustable rate mortgages, making it more difficult for home buyers to not only afford a home, but qualify for a loan in the first place. However, it’s important to keep in mind that, even with multiple rate hikes, borrowing costs will remain lower than the recent past. According to Freddie Mac, the average commitment rate on a 30-year fixed rate mortgage was 3.85% in 2015. That’s less than half of what it was in 2000.
Loans: Borrowing money in general will cost more when rates increase. This includes things such as car loans, credit cards and lines of credit in addition to mortgages.
Savings: A rise in the federal funds rate also means that banks will pay higher interest rates on savings. Consumers with money in their savings account will end up earning more money in interest.
Stocks: Rock bottom interest rates were a boon to the stock markets because it meant publicly listed companies could borrow more money at a reduced rate. Higher interest rates limit companies’ financing options and lessen the amount of money in circulation, tendencies that have a negative effect on equities.
Bonds: Bonds and interest rates have an inverse relationship, which means that bond prices will fall as rates go up and vice versa. If interest rates rise after your bond purchase, your coupon would be trading at a discount because all newly issued bonds would pay a higher interest rate.
US Dollar: Because higher interest rates attract foreign investment, they boost demand for the home country’s currency, thereby increasing its value. In fact, the mere speculation of higher US interest rates sent the US dollar soaring over 23% in the 18 months through December 2015. Multinational investment bank Goldman Sachs recently tipped the dollar as its best trade for 2016, citing diverging monetary policies between the Fed and other central banks.
Gold: Higher interest rates and a stronger dollar raise the opportunity cost of holding non-yielding, dollar-denominated assets such as gold. The yellow metal typically performs much better as an investment during times of low rates and high inflation.
While the effects of higher interest rates on your finances are generally well understood, there are no absolutes. Global finance is a complex ecosystem that doesn’t always lend itself to such cut and dry expectations. However, what you need to know is that tighter policy generally means reduced liquidity, higher borrowing costs and lower yields in the stock markets.
Investors need to also bear in mind that the Federal Reserve’s timetable for future rate hikes may be compromised, given the disastrous start to 2016 for the global financial markets. Wall Street experienced its worst two-week start to a year ever, as Chinese economic and financial instability unleashed waves of chaos across the globe. Chinese, Japanese and European markets officially entered into bear market territory in January, raising warning signs about the year ahead. Against this financial backdrop, the Federal Reserve will face several challenges setting forth a consistent policy strategy.