The Federal Reserve’s primary mission is to keep the U.S. economy running —not too hot, not too cold, but just “right”. When the economy “booms” and “runs hot,” things like inflation and asset bubbles creep out, threatening the overall economic stability. That’s when the Fed usually steps in and raises interest rates, which in return help cool down the economy and keep growth right on “track”.
The primary job of the Fed is to manage the monetary policy for the United States, which means controlling the supply of money in the country’s economy. While the Fed has multiple tools at its disposal for this task, its ability to influence interest rates is its key and most effective monetary policy tool.
When people talk about the Fed raising interest rates, they’re in fact referring to the ‘federal funds rate’, also called the federal funds target rate. At its regular meetings, the Federal Open Market Committee (FOMC) sets a target range for the federal funds rate, which acts as a reference for the interest rates big commercial banks charge each other for the overnight loans.
Banks borrow ‘overnight’ loans to satisfy liquidity requirements set by regulators, including the Fed. The average of the rates banks negotiate for overnight loans is called the effective federal funds rate. This in turn impacts other market rates, like the prime rate.
Because of this ‘link’, the federal funds rate is the most important benchmark for interest rates in the U.S. economy. It also influences the overall interest rates throughout the global economy as a whole.
So, what happens when the Fed raises rates?
When the Federal Reserve raises the federal funds rate, the aim is to increase the cost of borrowing throughout the economy. Higher interest rates make loans more expensive for individuals and businesses, and everyone ends up spending more on interest payments.
Higher interest payments discourage projects that involve financing. In addition, it encourages people to save money to earn higher interest. Overall, this reduces the supply of money in circulation, which tends to lower inflation and moderate economic activity. In other words, it cools off the economy.
The Fed reduces the amount of money in the economy when it raises rates. Rising interest rates impact the stock and bond markets, mortgages, credit cards, personal loans, student loans, auto loans and business loans.
How it impacts the Stocks Market?
Higher interest rate can have a negative impact on the stock market. When the cost of borrowing money increases, then the cost of doing business rises for companies. Over time, higher costs and less business could mean lower revenues and earnings for public traded companies, potentially impacting their growth rate and their stock values.
If the cost of borrowing money from a bank increases, the opportunity to expand investment in capital goods by a corporation stagnates. The interest rate may be so high that many companies will not be able to afford to growth. Ex. Technology companies.
An immediate impact of a Fed rate increase is the market psychology. The increase of interest rates have an impact on how investors feel about the market conditions. When the FOMC announces a rate hike, traders usually sell off quickly their stocks portfolios and move into more defensive investments. They don’t want to wait for the long and complicated process of higher interest rates to work their way through the entire economy.
How it impacts the Bond Market?
Bonds are very sensitive to interest rate changes. When the Fed increases interest rates, the market prices of existing bonds immediately decline. That’s because new bonds will soon be coming onto the market offering investors higher interest rate payments than the existing bonds. To reflect the higher overall rates, existing bonds will decline in price to make their comparatively lower interest rate payments more appealing to investors.
When prices in an economy rise, the Fed typically raises its target rate to cool down an overheating economy. Inflation erodes the actual value of a bond’s face value, which is a particular concern for longer maturity debts.
Interest rates are important.
Not all Fed interest rate increases are going to impact you directly, and not all corners of your investment portfolio are going to be affected by rate changes. However, keeping tabs on Federal Reserve monetary policy changes is an important part of keeping your financial life in order.
For all investors, especially those nearing retirement, a rising rate environment needs to be handled with extreme care. As in any other market condition, striking the right asset allocation among stocks, bonds and cash is the best way to mitigate the impact of rising rates.