Thought Leadership in Action

To no one’s surprise, the Federal Reserve raised the target range for its Federal Funds rate for the second time in 2018 and the seventh time in the current expansion, bringing the new range to 1.75%-2.00%.

“Information received since the Federal Open Market Committee met in May indicates that the labor market has continued to strengthen and that economic activity has been rising at a solid rate,” the Fed stated after its meeting.

“Job gains have been strong, on average, in recent months, and the unemployment rate has declined. Recent data suggest that growth of household spending has picked up, while business fixed investment has continued to grow strongly,” the Fed continued. “On a 12-month basis, both overall inflation and inflation for items other than food and energy have moved close to 2%. Indicators of longer-term inflation expectations are little changed, on balance.”

Of particular interest is that the Fed's committee members expect two more rate increases in 2018 and three more in 2019.

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.

For historical perspective, it’s important to remember that as a way to boost the economy, the Fed set its benchmark interest rate close to zero in late 2008.  This resulted in “free money.” By reducing the federal funds rate, the Fed increased the supply of money by making it less expensive to obtain.  As a result, businesses could have greater access to money and could spend more on building their businesses and on hiring more employees.  Because consumers and businesses had more money, they could purchase more goods, services, houses, and stocks.

Increasing the federal funds rate, on the other hand, 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.

Consequences for Consumers & Businesses

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

Effect on individuals – 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.  They must face the effect on what they want to purchase and when to do so. In other words, mortgage rates are going up and credit card interest rates are too. Same is true with auto loans.

Effect on business – 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. 

Specific Effects

The stock market as a whole – 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.

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

The federal budget – The U.S. government has a very large debt, and increased interest rates will lead to higher interest payments. 

Corporate borrowers – Companies that are repaying loans will end up with higher interest payments.

Mortgage holders – Payments on mortgage interest will increase for individuals and companies whose mortgages do not carry a fixed interest rate.

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

Here’s the Thing – No One is Surprised

This most recent rate hike was probably the most predictable and predicted rate movement the markets have ever seen. If the Fed starts moving rates higher and faster than expected over the next year, then we will see some challenges for the stock market and consumers. But for now, that’s unlikely to happen.

So, will there be implications of the Fed’s recent announcement? Sure. But enough to make most investors change allocations or courses of action? Probably not. Nevertheless, talk to your financial advisor if you have questions. 

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