How Rising Interest Rates Affect You
When you hear about the Federal Reserve it may be hard to imagine that their actions have a direct affect on you. The truth of the matter is that their policies, including those related to interest rates, are felt all the way down to the consumer level, for better or for worse.
It was recently announced that Jerome Powell took over the Fed Chair position from Janet Yellen. If you turn on the financial news, you will hear talk about the accommodative policies of the U.S. Central Bank, and Central Banks across the globe. The easy money policy first began in order to spur the economy after the collapse of 2008. The low rates brought on by the Fed were intended to make borrowing cheaper, which fuels the economy, however the low rates lasted longer than most economists imagined.
Currently, the Fed is in the process of raising interest rates from the recessionary levels to a more normal long-term rate. Even though the Fed only directly influences the inter-bank lending rate, the effects are felt across the economy. Interest rate increases affect the rate you receive in your savings account, the cost of a mortgage or car loan, the market value of your fixed income investments and even stock valuations.
As the Fed raises rates, borrowing becomes more expensive; not just for businesses, but for anyone who takes out debt. Consumers who take out new mortgages will have to pay higher rates than most have over the past 10 years. Individuals looking to refinance their mortgage may find that it is no longer economically viable, and those with floating rate mortgages will begin to see their monthly interest payments increase. Corporations are also exposed to similar increases in their cost of borrowing. Money they borrow to buy a new piece of equipment or open new facilities now costs more to pay back.
If you hold fixed income products in an investment account, you may notice the market value of the bonds declining in your portfolio. The decline occurs because as market interest rates rise, investors demand more return for a given amount of risk. The price of existing bonds can decline, inherently increasing the yield, making the risk-return profile more comparable to new, higher yielding debt. While this may seem concerning, it does not change the principal repayment you will receive or the nominal value of coupons you will receive according to the original terms of the bond.
On the whole, the increase in interest rates causes the economy to slow down as the money supply tightens. Why would the Fed want to slow the economy down? Isn’t growth supposed to be good?
The truth is that growth is good to a certain degree, but there is a such thing as an ‘overheating’ economy. The Fed’s purpose is to ensure stability, as represented by their dual mandate: full employment and stable inflation. The tightening that occurs when interest rates rise helps to curb inflation. The U.S. economy currently has an unemployment rate within the Fed’s range, which allows them to raise rates in order to combat potential inflation. It also helps to achieve their longer term goal of bringing interest rates back to normal levels. While it may make your mortgage more expensive, it could also boost the yields you receive in your retirement account. In the end, the Fed is attempting to act in the best interest of consumers over the long run; keeping the economy growing at a stable and maintainable pace.
Read about the benefits of contribution compounding here.