So the news is all talking about the recent interest rates hike announced by the Federal Reserve. The Federal Open Market Committee (FOMC), the Federal Reserve’s interest-rate setting panel, voted unanimously on Wednesday to raise the federal funds rate by 0.25 percentage points to a target range of 0.5% to 0.75%. So what does this really mean? Being a financial newbie who started investing, I know it’s important to keep up with the news. That’s why I decided to dig further and share my findings. I hope that my article can explain the effects of rising interest rates a layman term. Most importantly, how can we better prepare ourselves for the changes?
What is “the Fed”?
The Federal Reserve System, often referred to as the Federal Reserve or simply “the Fed,” is the central bank of the United States. It was created by the Congress to provide the nation with a safer, more flexible, and more stable monetary and financial system.
In 1977, Congress gave the Federal Reserve two main tasks: keep the prices of things Americans buy stable, and create labor-market conditions that provide jobs for all the people who want one.
Why adjust the interest rate?
The Fed adjusts interest rates to spur all sorts of other changes in the economy. But the adjustment doesn’t directly affect consumers like us. Instead, it affects the banks first. According to Business Insider, banks don’t only lend to consumers; they lend to each other as well. That’s because at the end of every day, they need to have a certain amount of capital in their reserves. As we spend money, that balance fluctuates, and so a bank may need to borrow overnight to meet the minimum capital requirement.
And just like they charge you for a loan, they charge each other. The Fed tries to influence that charge, called the federal funds rate, and is what they’re targeting when they raise or cut rates. When the fed funds rate rises, banks also hike the rates they charge consumers, and so borrowing costs increase across the economy. This will then indirectly affect consumers like us.
If the Fed wants to encourage consumers to borrow so that spending can increase, which should help the economy, it cuts rates and makes borrowing cheap. When people are spending like crazy, it raises rates so that an extra credit card suddenly doesn’t seem very desirable.
What’s happening next?
Although the interest rate hike this time is very minimal, it’s just the starting point. The FOMC signaled three rate hikes in each of the next three years. In the plot released after last December meeting, the median FOMC member saw rates rising to between 1.25 and 1.5% by the end of 2017. Given that the target range after that meeting was 0.5-0.75%, that suggests a total of three hikes of 0.25 percentage points each this year. In the longer term, the Fed expects a gradual schedule of hikes, with rates eventually settling around 3%.
So what’s the Effects of Rising Interest Rates?
Borrowing becomes more expensive
As mentioned earlier, when the Fed raises interest rates, borrowing among banks become more costly. The cost will soon be translated to the consumers and things like mortgages and credit cards rates will increase. If you are getting a house loan, do expect to pay more as interest rate will increase gradually in the next 3 years.
Advice: Get fixed-rate loan for your house if possible. For Singaporeans buying BTO, consider borrowing directly from HDB than from banks, as the former offers fixed rate. In terms of credit card spending, always spend within your capability. It’s always wise to pay on time to avoid incurring late charges.
2. Bank will pay more for your deposits, but…
Banks will have to revise their deposits interest rates eventually. That means you can expect your savings to generate more income for you in the next few years. But don’t be too contented. Banks profit from the spread between the rates they lend at and the ones they borrow at. In other words, they have little incentive to raise the interest they pay on deposits and cut into their profit margins.
What’s more, the current inflation rate for the United States is 2.7% for the 12 months ended February 2017, as published on March 15, 2017 by the U.S. Labor Department. That means, the money you gains from your saving interest becomes meaningless.
Advice: Putting money in the bank will never make you rich. Divide your money into different portions and invest some of them for growth. There are many financial instruments out there that can generate better returns, such as insurance, indexes and stocks.
3. Traveling becomes cheaper for US citizens, and vice versa…
According to Investopedia, the Fed hikes will continue to strengthen the US dollars. It is a good thing for the US citizens, as they can now travel cheaper when they go overseas. But for people living outside of the US, it’s a different case.
Advice: Since pound is greatly affected by Brexit, why not take the opportunity to visit the UK instead? There are also many affordable countries in Southeast Asia, such as Vietnam. Check out my complete Vietnam Travel Guide.
4. Stock prices will fall, except…
During this round of rate hikes, stocks hardly budged. The hike was modest, after all. But in the long run, ripples can rock the stock market. As interest rates increase, debts become more expensive for companies to finance. Higher debt expenses will cut into a company’s profits.
Higher interest rates also means a company may not be willing to borrow money much for growth, which translates to less revenue, so the estimated amount of future cash flows will drop. All else being equal, this will lower the price of the company’s stock.
With a lowered expectation in the growth and future cash flows of the company, investors will not get as much growth from stock price appreciation, making stock ownership less desirable.
Sounds gloomy? For value investors like me, it can be a good news. When people are fearful, good stocks are generally not appreciated. Some investors may even sell in panic, driving the stock prices to go down further. When the prices fall below the intrinsic values, it becomes a very good opportunity for value investors like us to go in. If the company has a strong moat and is able to generate profits consistently, it’s just a matter of time before the stock price will go up. If you want to find out more why I started investing and how I use it to fund my travel, check out my blog post.
In the meantime, there are some sectors that do benefit from interest rate hikes. One sector that tends to benefit the most the financial industry. Banks, brokerages, mortgage companies and insurance companies’ earnings often increase as interest rates move higher, because they can charge more for lending.
Advice: Find good companies that are undervalued to invest. Also keep a look out for companies from the financial industry and add them into your watching list.
Want to learn more about Value Investing?
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I hope you find my findings and advice useful. As I’m also a newbie who is trying to make sense of the “intimidating” financial world, my research is far from complete. If you have more things to add on, feel free to comment below and keep the learning going. I believe that with everyone’s effort and contribution, newbie like us will progress and eventually become experts one day.
Happy travel and investing! 🙂