On December 13th, 2017,
the Fed voted in favor of increasing interest rates by one quarter of a percent,
setting a new target range of 1.25% to 1.5%. To
explain what this means, it is important to understand why the Fed increases
(or decreases) rates, what role inflation plays, impact on the yield curve,
ramifications to markets, and how consumers will be impacted. Obviously, the
Fed’s use of interest rates can impact many areas.
The Federal Funds Rate is defined as the rate at which banks lend money
to other banks. The rate is set by the Federal Open Market Committee, also
known as the FOMC, which is a committee within the Federal Reserve, the Fed. This
rate is important for the overall economy because it affects all other loan
rates, is used as an indicator to show whether interest rates are rising or
falling, and sets overall monetary policy. The FOMC can increase or decrease
the interest rate at their multiple meetings, usually 8, during the year.
Generally, the Fed increases interest
rates to try to keep inflation at bay and maintain a strong dollar. When
inflation becomes too high, the U.S. dollar weakens, and the Fed must raise
interest rates to decrease the amount of money circulating in the economy.
Generally, when interest rates rise, loans become more expensive, which could
lead to a decrease in the amount of loans. The Fed has a target rate for
inflation of 2%, which is when they would expect to increase interest rates.
However, the inflation was at 1.7% at the time of the most recent rate hike,
leading many critics to wonder why the Fed would raise interest rates when
inflation was not at the 2% mark previously expected. In this case, the Fed
lifted rates preemptively, while forecasting that next year inflation should
continue to increase. To get ahead of this future inflation increases, they
preemptively increased the interest rates.
This topic relates back to many
topics we discussed in class, with the first being how it will affect bond
prices. The price of a bond is essentially the present value of all future
payments, including both the coupon payments and the face value paid at the end
of the coupon life. If the Fed raises interest rates, newly issued bonds now
must offer a higher yield to keep pace. This now makes existing bonds with
lower coupon payments less attractive and their price will fall. When
calculating bond prices, we divide by the interest rates typically so if the
interest rate rises, the bond price will decrease.
decision by the Fed also affects the yield curve. Given that the Fed expects
inflation to increase, it is very likely that they will increase interest rates
next year as well. Their current plans call for 3 increases in 2018, 2 in 2019
as well as 2020. If the market follows
the Expectation Hypothesis Theory, then the yield curve will have already
measured in this interest rate increase. If the Liquidity Preference Theory
holds, investors are going to want a premium considering that the interest
rates are likely to increase and therefore holding long-term bonds is now
riskier. Lastly, if the Segmented Markets Theory holds, this decision won’t
have much of an effect as investors who are into long-term bonds will still
trade long-term bonds and investors who are into short-term bonds will still
trade short-term bonds. While these theories provide differently shaped yield
curves, the current yield curve is flattening.
A flat yield curve means that
there is very little difference between short-term and long-term interest rates.
It is important to understand what this means for the overall economy. A
flattening yield curve is typically an indication for investors to be worried
about the macroeconomic outlook. One of the major reasons the yield curve may
flatten in today’s economy is that the market is expecting inflation to decrease
(or remain flat) or for the Fed to
increase interest rates, which would lead to a decrease in inflation. The Fed has
already indicated they are looking to increase the federal funds rate again in 3
times in 2018 so this would help explain why the yield curve is flattening. Longer-term
debt isn’t as impacted by the fed funds rate so while the short-term yield
curve is increasing, the longer-term yield curve drivers are not creating an
upward trending yield curve. Typically, when the yield curve is nearing
inversion, there can be market overreaction due to what normally happens after
the yield curve inverts. When the yield curve inverts, a recession is normally
only a year away. However, I would advise investors not to overreact as this is
somewhat of a self-fulfilling prophecy. As Janet Yellen said, “There is a
strong correlation between yield curve inversions and recessions, however, let
me emphasize that correlation is not causation”. I agree with Janet Yellen because other recession
warning signs simply are not present. The corporate bond market is still very
strong, and would normally weaken prior to a recession. Because of this, I do
not see any cause for concern over the current flattening yield curve and I see
it as a natural response to the increase in the federal funds rate.
While a flattening yield curve is typically
a reason for concern over the overall economy, I believe it would be helpful to
understand how the Federal Reserve played a role in the most recent financial
crisis and what a typical response to a financial crisis would be with regards
to the Fed’s actions. The financial crisis began in December of 2007 and ended
in June 2009. The Federal Reserve played a key role in trying to stimulate the
American economy during this crisis. To stimulate growth and prove to the
American people that they were committed to righting the sinking economic ship,
the Fed used multiple tools to stabilize the economy. First, in December of
2008, the Fed lowered rates to a range of 0% to 0.25%, the lowest possible
interest rate. During a recession, the Fed will lower rates as much as possible
to stimulate economic growth and increase consumer spending again as money will
be cheap. Second, since the Fed could not lower rates any lower, they used a
strategy that called Quantitative Easing, an unconventional monetary policy in
which a central bank purchases government securities or other securities from
the market to lower interest rates and increase money supply. During the
financial crisis, the Fed was buying back government bonds and mortgage-backed securities.
By increasing interest rates, the Fed signaled that they are not worried about
a recession and are encouraged by the low unemployment rate and economic growth
currently occurring. Therefore, the Fed must feel confident that they have the
proper tools to stave off a recession if one were to be seen on the horizon.
the Federal Reserve raises rates, the European Central Bank (ECB) tends to
follow suit and increase interest rates as well. However, the effect of this
Fed rate hike has not been seen in the European economy yet. When the European
Central Bank met on December 14th, they did not raise interest rates
as European Central Bank head Mario Draghi indicated that the European expansion
was in an earlier phase than that of the United States and therefore the
European economy still needed monetary support. By keeping interest rates low,
the ECB is attempting to keep more money circulating in the market. Since the
last recession, the ECB has followed the Fed’s lead in lowering interest rates
and adopting a Quantitative Easing policy. However, the ECB, and Europe’s
economy, has trailed the Fed’s actions. To conclude, while the European markets
tend to increase interest rates as a response to the Federal Reserve rate hikes,
it is to be seen if that will happen this time around.
Next, we can answer the question how the
rate increase affects bank stocks. Currently, the Fed has been steadily raising
short-term rates (3 times in 2017), while long-term rates have barely moved,
leading to a flattening of the yield curve. This means that while the Fed is
increasing short term interest rates, investors do not expect them to increase
in the future. Generally, banks make money by taking short-term deposits and
extending longer-term loans. Therefore, when short term interest rates are rising,
and long-term rates are not, banks margins significantly decrease. This would
make you think that banks stocks would be weakening in this current market.
However, this is not the case. Recently, bank stocks have been performing well,
mainly due to the excitement over the GOP tax overhaul and its impact on the
stock market. However, conceptually, this flattening yield curve would warrant
negative speculation about the future of bank stocks.
equities markets will also be affected by the rate hike. With interest rates
increasing, banks will now charge higher interest rates on loans. Companies
will find it harder to borrow money to allow them to grow and prosper. If a
company is cutting back its growth spending due to higher debt expenses, the
company’s cash flows will drop. Additionally, higher interest rates mean consumers
will no longer have as much disposable income as before and must cut back on
spending, resulting in businesses cutting back on equipment to increase
productivity and reducing the number of employees. When consumers are spending
less, major companies are earning less, leading to a decrease in their stock
price and value. While most major companies will suffer due to higher interest
rates, there are some exceptions. Most banks and insurance companies will
benefit in the stock market as they can now charge higher rates for lending. To
conclude, interest rate hikes tend to decrease consumer spending which leads to
a fall in company’s earnings and stock prices. However, it should be noted that
the Fed rate remains at a historically low level which mutes the impact of this
Fed rate increase impacts the yield curve, bank stocks, and the economy, but
the impact of the rate hike does not stop there. It is important to discuss
what this rate hike means for the average American consumer. With this rate
hike, there are five main aspects of personal finance that are affected: credit
cards, mortgages, auto loans, savings, and student loans. When the federal
funds rate increases, meaning that banks are now paying more interest, there is
a significant effect on the rest of the economy. With credit cards, the consumer
will now be paying more interest and according to CNBC, this 25-basis point
increase will cost credit card users roughly $1.46 billion in extra finance
charges in 2018. Mortgages are influenced by the economy, the Fed, and
inflation so this rate hike will impact mortgage rates as well. With interest
rates rising, adjustable-rate mortgages will certainly head higher as well.
There are two main types of mortgage loans: fixed-rate, which charge a set rate
of interest throughout the life of the loan, and adjustable rate mortgages, which
have fluctuating rates during the life of the loan. For existing fixed rate mortgages, this
interest rate hike will not impact what the consumer pays, However, new fixed
rate loans will see an increase in their payment. Conversely, both existing and
new adjustable rate mortgages will see an increase due to this hike. For
example, this rate increase of 25 basis points would cause borrowers of a
$50,000 loan to have increase in their monthly payment from $10 to $11. While
this is not a major increase, borrowers who are worried about escalation of the
rates can normally change to a fixed-rate option at any time. Auto loans
fortunately will not be impacted too severely by this rate increase. For
example, a quarter point of a difference on a loan for a $25,000 car would
amount to about $3 a month, which means as a car purchaser you should not be
too worried about this rate increase at all. Savings accounts most likely will
also not be affected too significantly by this increase. Banks generally do not
raise rates on saving products as quickly as they do with loans and credit
cards, allowing them to offer lower interest while making the consumer pay
higher interest rates. Lastly, student loans will also be impacted by this
rate, but not as badly as one would think. Federal student loan rates are
fixed, meaning that if you are a student who has already taken out loans that
you will not be impacted negatively by this rate hike. However, new student
loan fixed rates are likely to increase. If a student is taking out private
student loans, they should check whether these are through a fixed or variable
rate. If a student has a private variable rate loan their interest rates should
see an increase. Clearly, this rate hike by the Federal Reserve impacts both
banks and the everyday consumer.
Effect of the Fed Rate
1.46 Billion in extra
finance charges in 2018
Make sure to pay off
balances promptly to avoid increased finance charges or look for new credit
cards with a lower finance rate.
Mortgages will increase their rates
Change to a fixed-rate
option if worried about more rate increases in the future.
Will increase, but not
Do not do anything.
The increase is so insignificant it will not make a difference.
Banks are not likely
to significantly increase the rates on their customer deposits.
Check online savings
accounts, community banks, or credit unions. Often you can pick up more than
a full percentage point that way.
New fixed rate loans
will see an increase. Private variable-rate loans will also increase.
Identify which type of
loans you have. If you have a private variable-rate loan, see if you can change
it to a fixed-rate loan as more increases are likely to occur.
While the Fed only increased
interest rates by 0.25%, it is apparent how much of an impact interest rate
hikes have on the overall economy and market. This interest rate increase
affects inflation rates, bond prices, the yield curve, bank stocks, the
equities market, and the finances of the everyday consumer. The rate hike
affects many different areas relating to investments with varying degrees of
significance. While this increase rate did occur preemptively to keep inflation
at bay, I would expect to see the Fed to keep with their plans for 3 increases
in 2018 due to a strong economy and low unemployment, the GOP tax plan, and
further rollback of business regulations.