By Lt. Col. Shane Ostrom, USAF (Ret)
On Dec 14, the Federal Reserve raised the federal funds target rate, the first increase since December 2015. (That 2015 increase was the first in nearly a decade, since June 2006.)
You might be wondering, what do rising interest rates mean to investors? It’s a simple question — with an involved answer. Interest rates are a key variable in a complex mix of factors that impact our financial lives, influencing both the interest rate we earn on fixed-income accounts and the amount we are charged to borrow money or use credit.
Understanding the bigger picture may help you get a better handle on your money management.
The Board of Governors of the Federal Reserve, through the Federal Open Market Committeehttps://www.federalreserve.gov/pf/pdf/pf_3.pdf, controls the federal funds rate — the rate banks are charged to borrow money. The management of the interest rate is a tool used to help manage the nation’s economic situation.
It’s all about supply and demand: Interest rates help control the availability of money. Open up the supply of money, and it kick-starts the economy. If the money supply dries up, the economy slows down.
Controlling interest rates helps manage the supply of money, which helps manage the nation’s business cycle. The business cycle is the roller-coaster movement of our economy: businesses grow, peak, fall, hit bottom, and start back up.
Good and bad things happen as we go up and down with the cycle. Realize the down periods are natural and expected occurrences.
Let’s start at the bottom.
The media paint a picture of the country augering in, but in reality, it’s all part of the business cycle. Every down period of a cycle hits a bottom and rebounds.
At the bottom, interest rates usually are low. Inflation is low. Unemployment might be high, but businesses are starting to hire as they see a light at the end of a tunnel.
Low Federal Reserve rates allow banks to fill their cash reserves with cheap money, to encourage borrowing. Consumers and businesses borrow to spend, and spending creates growth in the economy.
Investors are poised for nice gains in the stock market as businesses begin to flourish. Bond holders and savers are not as happy because interest rates are low. Fixed-income savers look for other forms of investment returns, because interest rates can’t support them.
The growth phase.
The early part of the up-cycle is a positive time. Unemployment drops. Wages increase. More consumers consume more. Businesses profit. Inflation creeps in, with rising prices, as markets expand and business booms. Interest rates rise. Businesses and people continue to borrow before interest rates get too high.
Rising interest rates cause fixed-income investments to lose value: No one wants a bond that pays less interest than the new ones on the market. Plus, people don’t want an interest rate that falls too far behind the rate of inflation. It might help to consider money-market, short-term, or floating-rate fixed–income vehicles to stay up with rising interest rates.
Stocks tend to appreciate, with positive revenues. Commodities rise; housing, resources.
Eventually, inflation and higher interest rates cause businesses to struggle with increased operating costs, fewer consumers, and decreased revenues. Although businesses can increase prices for a while to stay profitable, before long, interest rates and inflation squeeze their profits. As a result, higher interest rates can contribute to decreasing stock values.
Some inflation can be a good thing, if it is a factor of a strong economy. However, inflation in excess of healthy growth is not a good thing. Higher interest rates can help control inflation.
Over the top and sliding down the hill.
At the top of the cycle, inflation and interest rates are high. Spending is in decline, businesses cut costs, and borrowing dries up. Eventually, interest rates drop to slow the economic decline and inflation starts to comes down.
Interest rates fall and fixed-income values rise. Fixed-income investors find rates decreasing, and the older higher-interest rate bonds provide better income but cost more. Fixed-income investors switch to long-term vehicles to lock in higher rates.
Stocks decline in value as business revenues continue to fall. Commodities start to decline. Then we start all over again.
So where are we now?
Just as no battle plan survives first contact with the enemy, academic models don’t always accurately predict the real-world economy.
We’ve been on a stock-market hot streak since March 2009, with only a hiccup in 2015. We are in the second-longest bull stock market in history. Good, right? Business must be great. So we are on the upswing?
However, the country’s growth rate is anemic. Business is OK but not robust. The gross domestic product (GDP), a measurement of the nation’s economic growth, is only at 2.9 percent, below the average of 3.2 percent. So we are heading down or at the bottom?
Interest rates are extremely low, indicating an unhealthy economy near the bottom. Inflation is also very low, indicating a slow business environment.
Unemployment is low, but with a caveat: Some unemployed, who want work, are not counted because they haven’t looked for a job in a while or because they work part-time because they can’t find full-time employment. These people make up 9.3 million unemployed.
So what does this mean to me?
The academic exercise above is nice, but it provides only a general sketch of possibilities. Have separate accounts based on your life objectives. Your objective will determine the style of management and the type of savings or investments. Manage those accounts by first considering the risk you are willing to assume and then balancing that against your expected returns. If we try to manage by returns only (do any of us really know where returns are going?), we could be surprised by the unexpected risk that bites us later. Visit www.moaa.org/financeblog to learn more.