The Federal Reserve in mid-March announced that for the first time in three years, they’re moving interest rates up by a quarter of a percent (0.25%). It followed that up on May 4 with a half a percent bump (0.5%), the biggest increase in over two decades. While these moves were expected, they are still going to cause some changes to the financial landscape as we know it.
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To gain an understanding of how rising interest rates may affect you personally, first you must understand what we mean when we talk about federal interest rates.
What do we mean by interest rates?
When we talk about the Fed, we’re referring to the federal government, specifically the Federal Reserve in this case. When you hear the phrase, “The Fed is raising rates,” what that really means is that the Federal Reserve is changing its target for the federal funds rate, which is the suggested rate that the FOMC (Federal Open Market Committee) uses. This rate, set by the FOMC, determines what commercial banks should charge when lending money to other banks. Banks then take their excess reserves and keep a percentage of them to cover deposits and lend the excess to one another in what is referred to as the overnight market. This isn’t a mandate that the banks do so, or a mandate of the exact rate they can charge, it’s just a suggestion, and what follows is a negotiation – but most banks follow these guidelines set forth by the FOMC and the federal funds rate.
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What does the rate impact?
The federal funds rate impacts inflation. The federal government has a mandate to keep inflation within the 2%-3% range, or what they call stable prices. The government believes 2%-3% inflation is a healthy, steady amount of inflation, and when inflation is either higher or lower than this amount, the federal government may use either accommodative or restrictive monetary policies in order to move inflation back to within the target range. Adjusting the federal funds rate is often their first choice to manipulate the rate of inflation.
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Lowering the federal funds rate is a tool the government has used when inflation is low, and the economy is in need of a boost. We’ve seen them use this to bolster the economy during recessions and during the start of the pandemic. In March, inflation hit 8.5%, and this is more than double the targeted range. Therefore, the federal government is moving to raise interest rates, which is a restrictive monetary policy to slow the circulation of money within the economy. With less money in circulation, it will discourage a sharp increase in prices.
How does the rise in rate impact you?
This rise in interest rates is somewhat expected, and we also expect the Fed to continue to raise interest rates during the remaining five meetings this year. While the current increases in 2022 have totaled 0.75%, with the added increases we may be looking at a 2% increase by year’s end.
This will affect your finances if you have anything in a variable rate vehicle, such as credit cards and variable rate loans, including car loans and adjustable-rate mortgages. If you can lock in a rate long-term, you may want to do that now, while rates are lower (relatively), instead of later, as they may go upadjust your timing.
Other possible effects of higher interest rates:
- We might expect to see that housing prices would cool.
- Bond yields will likely increase, and bond prices will likely fall.
- Generally, anything financial that is tied to an interest rate will be decently higher by the end of the year.
- Your savings account rates should also increase during this time frame, so you can get more interest on your savings account, particularly if you switch to an online-only bank with a higher interest rate.
Much of the market reaction that we’ve seen this part year, outside of the invasion of Ukraine, involved the repricing of interest rate expectations. The Fed has indicated that more interest rate increases are coming, so we can anticipate additional volatility. Investors need to remember that the market has ups and downs and that investing is a long-term strategy. This is where a financial adviser can help, because they can help investors counteract their own behavioral biases and avoid making snap decisions.
Working with a financial planner is always a good idea, as they can help you plan for what’s coming next in the markets, regardless of rising and falling interest rates.
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