The Federal Reserve exerts a high degree of influence over interest rates in the U.S. via the fed funds rate, which is the interest rate banks charge one another for overnight loans. The Fed’s Federal Open Market Committee (FOMC) is the body that sets this rate at its monthly meeting.
While the rate banks charge one another for a specific type of loan might seem pretty confined, a change in the fed funds rate can have a ripple effect on the economy. An increase in the fed funds rate increases the cost of funds for banks — a cost they ultimately will pass on to their customers, both individuals and businesses.
An increase in the fed funds rate invariably leads to an increase in the prime lending rate. This is the rate banks charge their most creditworthy business customers. Not only does this make borrowing more expensive for many companies, but many consumer interest rates — such as those on credit cards or short-term loans — may be tied to the prime rate and tend to increase when interest rates rise.
Beyond the obvious impact on borrowers and credit card holders, higher borrowing costs can ripple through the rest of the economy, including to your investments.
Recent changes in the fed funds rate
In 2018, the Fed has raised the fed funds rate three times so far, most recently on Sept. 26. The rate is now in the range of 2% to 2.25%. The rate has risen gradually from near zero in the years directly following the financial crisis of 2007, when the Fed kept rates low to help the economy recover.
In its most recent meeting in November, the FOMC agreed to hold rates steady in the range of 2% to 2.25%.
More recently, Federal Reserve Chairman Jerome Powell indicated on Nov. 28 that he felt the Fed’s current interest rate was “just below” the neutral range, meaning it was neither slowing economic growth nor causing the economy to grow at a faster rate than desired. Chairman Powell’s words can influence the markets. In October, he indicated that interest rates were “a long way” from neutral, as reported by CNBC, causing the stock market to plummet that month.
Where are interest rates headed in 2019?
Many experts differ on the direction of interest rates in 2019. Goldman Sachs and JPMorgan Chase reiterated their forecast for four fed funds rate hikes in 2019 right after Chairman Powell’s most recent speech. The consensus among economists also calls for a rate increase in December 2018, as previously anticipated.
What a Fed rate hike could mean for your investments
Rising interest rates impact most areas of the economy — including your investments. Here’s what to look out for.
Stocks and bonds
Bonds move inversely with interest rates. When rates rise, all things being equal, the price of existing bonds will decrease. Those investing in individual bonds could see the price go down. If the bond is held until maturity, investors will receive the full value of the bond. If they need to sell the bond prior to maturity, they may receive a price that’s lower than it would be if held until maturity.
Bond mutual funds and exchange-traded funds (ETFs) are impacted in a similar way but with a key difference. Since they are portfolios of bonds, the funds themselves never mature. An interest rate hike could reduce the value of the bonds held in the funds.
The impact on stocks, stock mutual funds and ETFs is a bit harder to gauge. Rising interest rates can lead to higher borrowing costs for many companies, which could impact the profits of companies who rely heavily on debt financing.
Rising rates also could hurt the revenue of companies whose business is dependent upon customers’ ability to borrow money, such as automobile manufacturers or homebuilders. Depending on how much stock of these companies you own or how prominently they are represented in ETFs and mutual funds you own, the impact could be adverse.
If interest rates rise, the residential real estate market also could be impacted. Higher mortgage rates impact buyers’ ability to borrow. This could serve to decrease the demand for housing, driving down prices. Besides prospective homeowners, this could impact those who invest in income-producing properties.
Similarly, the price of commercial real estate could see a decline if interest rates drive up the cost of loans to purchase commercial property. If financing is harder to get or the cost of borrowing is too high for some buyers, it could serve to drive real estate values down.
Real estate investment trusts (REITs), which own or finance various types of income-producing properties, also may suffer in value in a period of rising interest rates. There are many publicly traded REITs, which are essentially stocks, and many mutual funds and ETFs invest in REITs.
Rates for savers
Savers who use vehicles like CDs, money market mutual funds and other types of saving accounts could see an increase in the interest rate they earn when investing in these types of vehicles and accounts.
This provides a better return on these relatively low-risk savings vehicles. That could give a much-needed boost to investors who keep funds in these types of accounts, whether as a parking place for emergency cash or as a safe spot to stash a portion of their retirement savings.
Money held in your IRA and 401(k) accounts likely would not be impacted by rising rates, simply because of the structure of the accounts. However, as mentioned above, the investments held in these accounts could be impacted, potentially reducing the value of your retirement savings.
Final thoughts on Fed rate hikes
Increases in the federal funds rate can have a ripple effect on the economy and, by definition, on your investments as well. Interest rate-sensitive investments like bonds and real estate usually will see a direct impact. The same goes for rates on savings vehicles.
The impact on other types of investments, including stocks, may be more subtle. In any event, savers and investors should monitor these changes to understand the impact on their investment holdings.