Last week the Federal Reserve announced its intention to raise interest rates in 2022 to curb high inflation and stabilize the US economy. Low interest rates have helped keep inflation elevated as supply and demand imbalances were amplified due to the COVID-19 pandemic. While overall financial conditions are still good, this is partly due to government efforts to aid the economy and the flow of credit to US households and businesses. However, the steady increase of rising prices has caused many Americans to take a hit to the wallet and lessened our collective purchasing power.
But what does a rate hike mean? We recently talked with our President and CEO, John Slavic, to get his take on the state of the economy and what rising interest rates mean for you.
Q. What factors contributed to the central bank’s decision to raise the federal fund rate?
The inflation rate is currently at 7%, which is equal to where it was in 1982. The persistent nature of inflation has prompted the Federal Reserve to begin to take the steps to raise interest rates and reduce quantitative easing (infusing cash into the economy).
Q. When can we expect the new interest rates to go into effect?
According to the minutes from the Federal Reserve board meeting, the rate hike will occur in March 2022.
Q. How does raising interest rates help curb inflation?
Inflation is the erosion of the value of money. Paul Volcker, Chairman of the Federal Reserve in 1982 instituted monetary policy, so the government can control the supply of money and influence price stability. By raising interest rates, the cost of money goes up. For example, a mortgage that was obtained a few years ago at 3% could easily be 5-6% post-hike, increasing a homeowner’s monthly mortgage payments. As a result, the value of their house may be reduced due to the increased cost of money. If you apply that example across the economy, it has a significant dampening effect from industry to industry.
Q. What exactly will interest rates be raised on? Long-term fixed mortgages? Short-term borrowing rates (credit cards)?
Most revolving debt like credit cards is not tied to the federal funds rate. Other types of debt such as mortgages, lines of credit, and auto loans are tied to the federal funds rate.
Q. What impact do you expect this to have on household budgets?
Inflation by itself is a universal tax driving price hikes with things such as gas, a gallon of milk, a loaf of bread – the very things that make up or constitute a material portion of the household budget. Increasing interest rates should stabilize those costs, and in many cases, bring them back down. That is a welcome relief for those who have seen gasoline prices nearly double in the last couple of years. Alternatively, those who have a variable rate mortgage will pay the price with an increase in their monthly mortgage payment.
Q. Similarly, what impact do you expect this to have on the overall US economy?
It’s difficult to say. In general, higher interest rates slow down the economy and hence the inflation rate. Interest rates also have a significant bearing on the velocity of money, or the speed at which money flows through the economy. For example, consumers go to various stores to buy the things they need, creating transactions. Those stores do other transactions to replace the inventory that they sold. That inventory replacement transaction leads to numerous other transactions at the manufacturing level. When interest rates reduce or blunt the velocity factor in money, then prices fall, and stabilization takes place.
The US economy was artificially put into a suspended state. Not many businesses can survive weeks or even months without doing any business. As such, the federal government, through fiscal stimulus, passed relief bills injecting capital into the US economy, and cranked it up accordingly. The future impact is uncertain because of the artificial intrusion, with the Federal Reserve stepping in to infuse all this cash when they essentially drained cash at the beginning of the pandemic. So, I think we will see lots of gyrations in the economy before it works its way through to whatever the ‘new normal’ will be in the future.
Q. How will rising interest rates affect my 401(k)?
The market had a very difficult start in January, falling as rapidly as it did during the early days of the pandemic by 10% or more in each of the three major indices – Dow Jones, NASDAQ, and S&P 500 – putting them squarely in correction territory. This is the market anticipating six-to-nine months into the future as to what the economy is going to do. At this stage, given the significant, sharp, and sudden drop in the markets, that’s already built into the stock markets cost right now. So, it’s not as if the stock market doesn’t know about the advent of rising interest rates. It does, and it’s already responding.
The market will then determine what the likely path of the economy will be one-to-two years from now, after all the turbulence we experienced in January 2022. There is a slight increase in the dividend rate in bond funds, money market funds and so on – it’s immaterial compared to the losses that can be experienced by the market in general. Rising interest rates generally have a negative effect on the stock market, and hence 401(k) account balances. The best approach in the 401(k) account is to utilize these periods of decline or deterioration in the market to accumulate additional shares at a lower price of whatever mutual fund allocation the investor has, waiting for the market rebound — which inevitably comes. So, for the 401(k) investor, consistently deferring into their account through payroll deductions and a risk adjusted portfolio that’s properly diversified, makes all the difference in long-term success.
The commentary and market insights provided by John Slavic are for informational purposes only and do not guarantee future results