The Federal Open Market Committee lowers the target rate when economic stimulus is needed, and raises it to limit inflation and avoid overheating as the economy expands. In the decade after the Great Recession, rate concerns faded. The Fed’s target rate hit 0% in late 2008 and was 0% for 7 years. Low rates became the norm, mortgage rates hit historic lows, and bank savings accounts paid close to nothing.
Since 2015, rates were upped 7 times, including 2 hikes in 2018, to a still-historically-low 1.75% – 2%, reflecting the Fed belief that the economy is healthy. Unemployment is low, and wages, consumer spending and borrowing are creeping up, suggesting that the low-rate stimulus plan can be lifted.
As a near-term side effect, rising rates drive down bond prices. Fed rates have a direct impact on short-term bonds, and a more indirect impact on longer-term bonds, given their inflation sensitivity. However, rate increases lead to higher bond portfolio returns over time, benefiting retirees and others.
Banks responded slowly to Fed action, but savings account and CD rates are now up to over 2%. U.S. Treasuries, which respond quickly to rate changes and are exempt from state income taxes, became more appealing than cash. As for borrowers, higher interest rates make new and variable rate debt more expensive, especially home equity lines of credit, due to changes to the tax-deductibility of interest on HELOCs. On the flipside, those who already have fixed-rate mortgages benefit from the higher inflation the Fed wants to control, if work income rises relative to a borrower’s fixed payments.
What’s next? The Fed Committee plans to continue to gradually increase rates through 2019 if economic growth continues. The Fed also expects a new lower-than-average “normal” for rates, given the healthy, but slower than average, economic growth expectations.
That said, attempts to predict the market remain imprudent. In the April 20, 2010 New York Times article “Interest Rates Have No Where to Go But Up,” well-known money managers predicted rates would be up 1.5% by the end of 2010. They were right about the increase, but the timing was off… by 7 years. Rates didn’t increase by a total of 1.5% until early 2018, further demonstrating the benefit of the sound, long-term perspective that we advocate at The Advisory Group.