What Raising Interest Rates Really Means

The Federal Reserve has a lot of influence on our economy. I mean A LOT. Their main job is to make policy decisions around setting interest rates, regulating financial markets, and managing the money supply. Suffice it to say, they control the economy (see: us). A little scary, right?

Early last year when COVID hit, the economy took a dip when businesses were forced to shut down and lay off workers. Since then, however, thanks to record low interest rates, stimulus checks, and PPP loans for small businesses, the economy has been on a tear. We can see that in how consumers are spending, the competition for housing, used car values, and ultimately how that has affected the prices for necessities such as food and gas.

The problem is, the Fed shrugged off warnings for far too long, calling the situation “transitory”, and have put us into an inflationary period (see previous blog post) that we haven’t seen since the early 1980’s. So, now they are finally taking things more seriously and we are hearing they will be raising interest rates no less than 4 times this year. What does this mean? Raising interest rates is meant to put the brakes on an overheated economy, making it less attractive to borrow money, causing consumers to cool spending, and forcing businesses to decrease prices. Let’s take a deeper dive into 3 main areas where a rise in interest rates will impact us.

The Cost to Borrow Will Go Up

Remember when you could purchase a home with really good credit and get an interest rate around 3%? Not anymore. When the Fed increases interest rates, this is one of the first places you will notice a change. If you have an ARM (Adjustable Rate Mortgage), your mortgage payment will go up, so now might be the time to refinance and lock in a fixed rate before additional increases take effect. Also, if you are in the market for a car, applying for personal loans, or other consumer debt, you may notice those rates going up as well.

Your Retirement Account May Go Down

You probably own individual stocks or bonds, mutual funds or ETF's (Exchange Traded Funds) made up of bonds and stocks in your retirement or other investment accounts. Well, bonds have an inverse relationship with interest rates. This means that when interest rates go up, the price of existing bonds go down because new bonds are more attractive at the higher rate. This is particularly true of longer term bonds, which have a higher sensitivity to rate changes. Some stocks may also take a dip because taking additional risk in the stock market will be less attractive if savings rates are up (see my final point below). In addition, less consumer borrowing and spending will affect some companies' bottom lines, driving down their stock prices. This should be temporary, however, as the effects of rising rates begin to level out, ideally returning the economy to a more manageable inflation level. Remember, if you do not plan to draw down on your investments for 10 years or more, these dips should not be a cause for concern.

Your Savings Account Rate May Go Up

Wow, finally some good news! Yes, sorry, I was saving the best for last. These may take a little longer to catch up, but financial institutions should start raising savings interest rates, giving you a better return for that emergency money. Online banks pay a much higher rate than brick-and-mortar institutions, so if you aren’t tied to your credit union or bank, check out online banks. You can start with www.bankrate.com to see who is paying the best rate. Also, CD’s should see a bump in rates, too.

Summary

The effects of the Fed raising interest rates will affect all of us in one way or another. If you are planning to borrow money, invest, or save for a rainy day, be aware that changes will be occurring this year and you may need to make some decisions around your finances. A trusted financial advisor can help. Ultimately, the goal is to combat inflation and bring prices back down to pre-COVID levels, so it’s not all bad! How and when inflation subsides, however, is yet to be determined.