On December 16, the Federal Open Market Committee (FOMC) raised the benchmark federal funds rate to a range of 0.25% to 0.50%, the first increase from the near-zero range (0% to 0.25%) where it had lingered since December 2008.1
In response to the widely expected decision, the stock market rallied, reflecting a collective sigh of relief that the U.S. economy is finally deemed healthy enough to withstand slightly higher interest rates. The Dow Jones Industrial Average rose 224 points or about 1.3%. The yield on two-year U.S. Treasury notes settled above 1% for the first time in more than five years, while 10-year Treasury yields were little changed.2
The Federal Reserve and the FOMC operate under a dual mandate to conduct monetary policies that foster maximum employment and price stability. Adjusting the federal funds rate up or down is one of the ways the central bank can influence short-term interest rates, economic growth, and inflation. The Fed faces the tricky task of removing unprecedented levels of support early enough to keep inflation from flaring up, but not so quickly as to reverse economic progress or upset financial markets.
Policy Tools Tested
The federal funds rate is the interest rate at which banks lend funds to each other overnight to maintain reserve requirements at the Fed. It serves as a benchmark for many short-term rates set by banks. Lowering interest rates fuels demand for credit and encourages consumers and businesses to spend and invest. Raising interest rates helps to slow economic activity when inflation is seen as the larger threat.
The FOMC expects economic conditions to “warrant only gradual increases,” and the median projection by 17 Fed officials was for the federal funds rate to reach 1.375% by the end of 2016.3 This means investors should expect to see additional small rate hikes this year.
In the wake of the 2008 financial crisis, Fed officials conducted three rounds of quantitative easing to help push down longer-term yields — essentially creating money to buy up bonds. This bond-buying program ended in 2014 but left the Federal Reserve with a much larger balance sheet. Reducing the Fed’s $4.5 trillion bond portfolio could disrupt the markets, so officials will keep holdings at the same level until rate increases are “well under way.”4
In 2012, the FOMC set a goal of 2% for inflation, but consumer prices have remained stubbornly low. According to the Fed’s preferred measure of inflation (core PCE), prices increased at an annual rate of only 1.3% in October 2015.5
Why was the federal funds rate lifted when inflation is still well below the stated target? The Committee expects that labor market conditions will continue to strengthen and is “reasonably confident” that inflation will rise to 2% over the medium term. It takes time for monetary policies to work, and the Committee wants to avoid a situation in which rates might need to be increased “abruptly” if inflation suddenly heats up.6
When interest rates rise, the value of existing 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 when a bond is held to maturity, the bond owner would suffer 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 on heavy borrowing will likely face higher costs going forward, which could affect their bottom lines.
Consumer Credit and Savings
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 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 from bank accounts, CDs, bonds, and other fixed-interest investments could eventually benefit from higher yields.
Keep in mind that future Fed policies will depend on ongoing assessments of economic data and growth projections. If inflation rises more or less than expected, rate adjustments will likely follow suit, despite any previous forecasts.
The financial markets could continue to react — and occasionally overreact — to policies announced by the Federal Reserve. 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 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. The FDIC insures CDs and bank savings accounts (up to $250,000 per depositor, per insured institution), which generally provide a fixed rate of return.
1, 3, 5–6) Federal Reserve, 2015
2, 4) The Wall Street Journal, December 16, 2015
The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. Copyright 2016 Emerald Connect, LLC.