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Thought Leadership in Action

Federal Reserve Raises Rates for the 4th Time

But Fed officials now forecast two rate hikes in 2019, down from three

From the Federal Reserve press release dated December 19, 2018:

“Information received since the Federal Open Market Committee met in November indicates that the labor market has continued to strengthen and that economic activity has been rising at a strong rate. Job gains have been strong, on average, in recent months, and the unemployment rate has remained low. Household spending has continued to grow strongly, while growth of business fixed investment has moderated from its rapid pace earlier in the year. On a 12-month basis, both overall inflation and inflation for items other than food and energy remain near 2 percent. Indicators of longer-term inflation expectations are little changed, on balance.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee judges that some further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee's symmetric 2 percent objective over the medium term. The Committee judges that risks to the economic outlook are roughly balanced, but will continue to monitor global economic and financial developments and assess their implications for the economic outlook.

In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 2-1/4 to 2‑1/2 percent.”

No One Was Surprised

This 4th rate hike – as were the three previous hikes – was one of the most predictable and predicted rate movement the markets have ever seen.

Yet while the markets and traders were expecting this hike, the announcement did contribute to the DJIA, NASDAQ and the S&P 500 all hitting new lows for 2018. But that’s only one trading day – long-term investors should think about the risk that the Fed starts moving rates higher and faster than expected throughout 2019, because then we could see some longer-term challenges for the stock market and consumers. But for now, that’s unlikely to happen.

So, will there be implications of this announcement? Sure. But enough to make most investors change allocations or courses of action? Probably not.

Reason to Change

The most important tool available to the Fed is its ability to set the federal funds rate, or the prime interest rate.  This is the interest paid by banks to borrow money from the Federal Reserve Bank.  Interest is, basically, the cost to the banks of borrowing someone else’s money.  The banks will pass on this cost to their own borrowers.

Increasing the federal funds rate reduces the supply of money by making it more expensive to obtain.  Reducing the amount of money in circulation, by decreasing consumer and business spending, helps to reduce inflation.

Effects for Consumers and Businesses

Any increased expense for banks to borrow money has a ripple effect, which influences both individuals and businesses in their costs and plans.

  • Banks increase the rates that they charge to individuals to borrow money, through increases to credit card and mortgage interest rates. As a result, consumers have less money to spend and must face the effect on what they want to purchase and when to do so. In other words, mortgage rates are trending up and credit card interest rates are too. Same is true with auto loans.
  • Because consumers will have less disposable income (in theory), businesses must consider the effects to their revenues and profits. Businesses also face the effect of the greater expenses of borrowing money.  As the banks make borrowing more expensive for businesses, companies are likely to reduce their spending.  Less business spending and capital investment can slow the growth of the economy, decreasing business profits.

These broad interactions can play out in numerous ways. 

Effects on the Markets

This one is a bit trickier because intuitively stock prices should decrease when investors see companies reduce growth spending or make less profit.  The reality, however, is that the Fed typically won’t raise rates unless they deem the economy healthy enough to withstand what should – at least in textbooks – slow the economy. But the reality is that stocks often do well in the year following an initial rate hike. But after 4 rate hikes in the same year? Much tougher to predict.

If the stock market declines, investors tend to view the risk of stock investments as outweighing the rewards and they will often move toward the safer bonds and Treasury bills.  As a result, bond interest rates will rise, and investors will likely earn more from bonds.

Obviously, many factors affect activity in various parts of the economy.  A change in interest rates, although important, is just one of those factors.

© 2019 RSW Publishing. All rights reserved. Distributed by Financial Media Exchange.


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