Interest Rates Are Going Up, Now What?

“The times they are a’changin’” – Bob Dylan

In financial circles, it’s referred to as tightening monetary policy. For the average American, the Federal Reserve raising interest rates has ramifications beyond the immediately visible. With the current expectations being that the Fed will likely raise its key interest rate possibly up to four times in 2022, this piece will examine the impact of higher rates.

It is important to clarify what I mean by the general term “interest rates.” As has been previously discussed in this space, Federal Reserve policy is aimed at short-term rates. There is a difference between these rates and the rates that dictate current mortgage rates. Like turning a thermostat, the Fed sets these rates to control inflation or boost an economy needing some juice. Inflation is this year’s theme, so the Fed will raise rates to moderate the economic temperature.

The most straightforward effect of higher interest rates will be seen in savings accounts. As banks can earn more money on their short-term holdings, they can pay higher interest rates on savings accounts and certificates of deposit. I wouldn’t expect a one-for-one increase in those rates related to how much the Fed raises – banks will look to earn a spread on what they earn versus what they pay for short-term rates. If you are looking for an advantageous spot to park your cash, it is helpful to shop around and consider online savings accounts. Online savings accounts can pay higher rates because they don’t have the overhead costs of traditional banks.

A secondary effect of higher rates will be (and is currently being) felt in the stock market. This doesn’t mean a direct, inverse correlation between interest rates and your portfolio balance (the stock market has tended to increase at the beginning of a rate hike cycle). It does, however, change where money flows within the market. It is said that money flows to where it is treated best and as interest rates increase, investors rethink investing in companies with little-to-no current earnings. The explanation for this is a bit nuanced. In its most basic form, higher interest rates have a built-in opportunity cost concerning high-growth stocks and a psychological effect for those previously accustomed to “easy” monetary policy. In fact, we have already seen the stocks of many of these types of companies commence a steep decline in anticipation of higher rates.

Finally, and somewhat hopefully, higher interest rates should theoretically stem the tide of increased prices that we all see in our daily lives. Inflation is typically a silent killer, but the inflation we have seen over the last year has been hard to miss. The COVID-related issues that affect supply chains will hopefully subside soon, and tighter monetary policy will aid in stemming the tide of higher prices. The risk exists that the Fed hits the brakes too hard and the economy slows too much, but that is a discussion for another time. For now, the focus is on the task at hand.

Talking to your financial advisor is always prudent regarding these and other matters. Knowing how these changes affect you is part of a good strategic plan.

Author: David Rath, CFA

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