Anybody who was surprised that the Federal Reserve Board decided to raise its benchmark interest rate in December 2016 probably wasn’t paying attention. The U.S. economy is humming along, the stock market doing well, the unemployment rate has fallen to a low level -- now considered to be 'full employment.' We are more recently seeing evidence of increasing wages as well.
The rate rise is extremely conservative: up 0.25%, to a targeted range from 0.50% to 0.75%—which, as you can see from the accompanying chart, is just a blip compared to where the Fed had its rates ten years ago when it was north of 5%. Keep in mind the prime rate -- more commonly used in consumer finance -- is the federal funds rate plus 3%. So prime was north of 8% in 2007.
The bigger news was the announced intention to raise rates three times next year, moving to a more “normal” 3% by the end of 2019. This is faster than prior market expectations, heading into the meeting, although still somewhat conservative. Whether any of that will happen is unknown. After all, in December 2015, the Fed was indicating two and possibly three rate adjustments in 2016 before backing off until now.
The rise in rates is good news for those who believe that the Fed has intruded on normal market forces, suppressed interest rates much longer than could be considered prudent, and even better news for people who are bullish about the U.S. economy. The Fed's announcement acknowledged the sustainable growth in economic activity and low unemployment as positive signs for the future. However, bond investors might be less pleased, as higher bond rates mean that existing bonds lose value. The recent and quick rise in bond rates at least hints that the long bull market in fixed-rate securities—that is, declining yields on bonds—may be over.
For stocks, the impact is more nuanced. Historically stocks tend to do well and not be impaired by modest interest rate and inflation increases where fast increases tend to hurt. Plus bonds and other interest-bearing securities compete with stocks for your capital investment. As interest rates rise, the see-saw between whether you prefer stability of bonds or higher expected growth of stocks tips a bit, and some stock investors move some of their investments into bonds, reducing demand for stocks and potentially lowering future returns. None of that can be predicted in advance, and the fact that the Fed has finally admitted that the economy is capable of surviving higher rates should be good news for people who are investing in the companies that make up the economy.
The bottom line here is that, for all the headlines you might read, there is no reason to change your investment plan as a result of a 0.25% change in a rate that the Fed charges banks when they borrow funds overnight. There is always too much uncertainty about the future to make accurate predictions, and today, with the incoming administration, the tax proposals, the fiscal stimulation, and the real and proposed shifts in interest rates, the uncertainty level may be higher than usual.
For those that have trouble sleeping, you may also read the growing body of academic literature that provides compelling evidence that the Fed has little to no effect on real interest rates in the economy. Rather, markets supersede the Fed and determine these. No doubt we saw the same recently.
To Your Prosperity,
Kevin Kroskey, CFP®, MBA
This article adapted with permission from BobVerese.com.
Sources:http://www.businessinsider.com/fed-fomc-statement-interest-rates-december-2016-2016-12
http://www.marketwatch.com/story/fed-to-hike-interest-rates-next-week-while-ignoring-the-elephant-in-the-room-2016-12-09
http://www.reuters.com/article/us-usa-fed-idUSKBN1430G4The rate rise is extremely conservative: up 0.25%, to a targeted range from 0.50% to 0.75%—which, as you can see from the accompanying chart, is just a blip compared to where the Fed had its rates ten years ago when it was north of 5%. Keep in mind the prime rate -- more commonly used in consumer finance -- is the federal funds rate plus 3%. So prime was north of 8% in 2007.
The rise in rates is good news for those who believe that the Fed has intruded on normal market forces, suppressed interest rates much longer than could be considered prudent, and even better news for people who are bullish about the U.S. economy. The Fed's announcement acknowledged the sustainable growth in economic activity and low unemployment as positive signs for the future. However, bond investors might be less pleased, as higher bond rates mean that existing bonds lose value. The recent and quick rise in bond rates at least hints that the long bull market in fixed-rate securities—that is, declining yields on bonds—may be over.
For stocks, the impact is more nuanced. Historically stocks tend to do well and not be impaired by modest interest rate and inflation increases where fast increases tend to hurt. Plus bonds and other interest-bearing securities compete with stocks for your capital investment. As interest rates rise, the see-saw between whether you prefer stability of bonds or higher expected growth of stocks tips a bit, and some stock investors move some of their investments into bonds, reducing demand for stocks and potentially lowering future returns. None of that can be predicted in advance, and the fact that the Fed has finally admitted that the economy is capable of surviving higher rates should be good news for people who are investing in the companies that make up the economy.
The bottom line here is that, for all the headlines you might read, there is no reason to change your investment plan as a result of a 0.25% change in a rate that the Fed charges banks when they borrow funds overnight. There is always too much uncertainty about the future to make accurate predictions, and today, with the incoming administration, the tax proposals, the fiscal stimulation, and the real and proposed shifts in interest rates, the uncertainty level may be higher than usual.
For those that have trouble sleeping, you may also read the growing body of academic literature that provides compelling evidence that the Fed has little to no effect on real interest rates in the economy. Rather, markets supersede the Fed and determine these. No doubt we saw the same recently.
To Your Prosperity,
Kevin Kroskey, CFP®, MBA
Sources:http://www.businessinsider.com/fed-fomc-statement-interest-rates-december-2016-2016-12
http://www.marketwatch.com/story/fed-to-hike-interest-rates-next-week-while-ignoring-the-elephant-in-the-room-2016-12-09
http://www.usatoday.com/story/money/personalfinance/2016/12/15/fed-rate-hike-7-questions-and-answers/95470676/?hootPostID=32175354f7440337d62a767b3db92c68