It’s been big news everywhere in the financial world for a while now. The Federal Reserve, the U.S. central bank, finally made its move this month and decided to raise short-term interest rates.
These are the rates at which banks borrow money from each other. The Fed also projected that there might be as many as three additional rate hikes next year. Additionally, Donald Trump’s presidential election victory and speculation about what his economic policy might look like has pushed interest rates up in recent weeks.
We thought we would take a look at why the Fed occasionally messes with interest rates. After that, we’ll get into the effects for consumers.
Inflation Inhibition
An original goal specified by Congress when setting up the Federal Reserve was that it should maintain stable prices, keeping the cost of goods and services from getting too high or too low.
The main tool that the Fed has for doing this is controlled short-term interest rates. For the better part of the last decade, we’ve been in a cycle where the Federal Reserve has wanted to keep money free-flowing and borrowing costs low. It’s been cheaper for banks to borrow money from each other, with banks passing that onto regular consumers looking to pay for a house or car.
While low-cost borrowing can be great, there can be too much for good thing. That’s when inflation happens. Eventually, if there’s too much money floating around, it doesn’t hold the same value. If I were elected President Graham tomorrow (shudder), and I decided everyone gets 50 $100 bills, we might find ourselves paying $25 or more for a loaf of bread.
Admittedly, that’s an oversimplified example, but the Fed has to balance keeping borrowing affordable for Americans with the need to keep inflation in check. In order to keep inflation from getting out of hand, the Fed will occasionally choose to raise short-term borrowing costs for banks. In turn, this means borrowing gets more expensive for the consumers of the bank. If the Fed feels borrowing has become too expensive, they lower rates again.
Consumer Effects
Now that we’ve learned what the Fed does and why my Monopoly money monetary policy would never work, let’s take a look at what it all means in the real world. How do rising interest rates affect you?
Mortgages
Let’s start with something we know quite a bit about – the mortgage market.
Mortgage rates have certainly gone up recently. Rates started going up after the election and they haven’t stopped yet. The election played into this. The market had also expected the Federal Reserve to raise interest rates in December, so that was accounted for in mortgage rates before the decision was ever made. However, there was one thing the market did not expect.
Prior to December, the Federal Reserve had projected two interest rate increases over the course of 2017. At its final meeting of the year, the Fed decided to change its projections to include three interest rate increases in that timeframe. This had the effect of pushing more money out of bonds, making mortgage rates higher.
Bonds give a fixed rate of return. That means they’re not a great investment in an environment where there’s a lot of inflation. For example, you buy a $100 bond for $50 with a term of 10 years. Sounds like a good deal, right? Invest $50 and get back $100. Sure, it is. However, there’s the possibility that if you invest that $50 in a certificate of deposit, you could’ve turned it into $200.
If the Fed is raising interest rates, it means the central bank thinks inflation is going to soon reach a level that needs controlling. Again, inflation is not good for bonds.
When people have a feeling they could make more money elsewhere, they leave one market for the other. That’s what’s happening with stocks and bonds right now. No one knows for sure what’s going to happen with the economy when President-elect Trump takes office, but the stock market is way up because people think his policies will be good for business. This encourages people to take a little risk on the success of companies rather than stay in the safety of bonds.
Whether you’re looking to buy or refinance, rates are still relatively low at this point, especially in comparison to other times in history. However, if you’re on the fence, it’s an excellent time to lock that low rate.
Other Interest Rate Effects
Although we talked to this point about the impact of rising interest rates have mortgages, it would also have a high impact on things like variable rate credit cards, where the interest rates periodically change with the market.
Get More Out of Your Savings
The Federal Reserve is raising interest rates in order to make borrowing more expensive and combat inflation, but this has a sneaky positive effect as well.
If banks have to pay more to borrow money, that makes the money you’ve been keeping with them that much more valuable to them. Because of this, you should be able to start getting more money out of your savings, CDs, etc.
Impact of a Stronger Dollar
As inflation is brought under control, this has an interesting impact on a global level. For the same reason your savings account grows, your money becomes more valuable compared to other global currencies if there’s less of it in the marketplace. This has two effects:
- That futuristic Japanese toilet and all manner of other imports become cheaper for us to buy because our money is worth more.
- Our exports become more expensive for other consumers around the world as the dollar strengthens. This is what the Fed has to keep an eye on because they don’t want the higher prices to cause a sales slump for American companies.
Hopefully this has given you a better idea of what this new, higher interest rate environment might mean for you. It’s also important to realize they’re still not all that high right now. If you’re looking to buy or refinance soon, check out current mortgage rates.
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