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Figuring Out the Fed - An Interest Rate PrimerSubmitted by Townsend Asset Management Corp. on July 11th, 2017
The media and the financial markets breathlessly await and fret over the actions taken by global central banks, as these actions affect the money supply and interest rates. Our central bank, the Federal Reserve (“the Fed”), has the mandate "to promote sustainable growth, high levels of employment, stability of prices to help preserve the purchasing power of the dollar and moderate long-term interest rates. In other words, the Fed's job is to foster a sound banking system and a healthy economy.
Two key interest rates the Fed sets are the “discount rate” and the “federal funds rate.”
The discount rate is the interest rate the Fed charges when banks borrow money from the Fed. This rate is currently 1.75%, up from 1.00% a year ago. The federal funds rate is the rate banks charge each other for overnight loans, and this rate is currently 1.25%, up from 0.50% a year ago.
In the aftermath of the 2007 recession, the Fed dropped the federal funds rate to a 0.00% - 0.25% range to stimulate the economy and generate job growth, and the rate remained at that historic low for seven years. Since December, 2015 the Fed has very gradually bumped the rate up while keeping a wary eye on economic growth and inflation. The Fed has set a 2% annual inflation goal as consistent with healthy economic growth.
Given the slowness and fragility of the global economic recovery and the measured pace the Fed has so far demonstrated, no one expects these rates to increase dramatically in the short-term. Nevertheless, they are on an increasing path, with implications for borrowers, savers and investors.
The “prime rate” is the interest rate banks charge their best customers and is typically tied to the federal funds rate. Small business loans, home equity loans, car loans and credit cards are often linked to the prime rate. The current prime rate is 4.75%, up from 3.50% a year ago. Increases in the prime rate obviously increase borrowing costs.
Student loan rates are also rising. Direct Subsidized and Unsubsidized Loans to undergraduate students for the 2017/2018 year are 4.45%, up from 3.76% a year ago.
While rising rates are costly for business and consumer borrowers, long-beleaguered savers benefit from higher yields on savings accounts and CDs. However, this doesn’t happen immediately, and lags the increase in borrowing rates.
The Fed only sets short-term rates. Financial markets determine long-term rates. Logically, if the Fed bumps up short-term rates due to a strengthening economy, you would expect longer-term rates to also move up. However, this logic doesn’t always hold as investor’s concern over the health of the economy could result in longer-term rates moving down, even while short-term rates climb upwards. Nevertheless, over time, in a healthy economy, longer-term rates would also rise, causing the value of existing bonds to decline. Why? Investors prefer buying a new bond paying a higher interest rate than an older, existing bond paying a lower rate. Therefore, in a rising interest rate climate, bond investors have the wind in their face. Shorter-maturity bonds and bonds with adjustable rates are ways of addressing this challenge. In addition, “high yield” bonds (lower quality bonds that pay higher interest) may be an alternative, as their higher yield somewhat offsets the drag of rising interest rates.
The stock market is also impacted by rising interest rates, but not as directly as the bond market. Assuming interest rate increases reflect a robust economy, this means that corporate earnings, and stock values are also benefiting. At the same time, companies borrow money and higher interest costs negatively impact their bottom line, potentially dampening stock prices. And as interest rates on savings accounts and newly-issued bonds rise, they act as competition for stock investors, making stocks less attractive for investors.
The relationship between the economy, interest rates, and the financial markets is complex. When the Fed adjusts rates, there is often a temporary immediate reaction in the markets. Ultimately, what matters is how the economy performs as these rates change. Finally, it is important to keep a long-term viewpoint and focus decisions around your unique financial goals and time frame.
Gerald A. Townsend, CPA/PFS/ABV, CFP®, CFA®, CMT is president of Townsend Asset Management Corp., a registered investment advisory firm located in Raleigh, North Carolina. Email: Gerald@AssetMgr.com