In a widely expected move, the Federal Reserve raised the Fed Funds target rate range from 0-0.25% to 0.25-0.50% earlier today. They forecast a gradual (though not set in stone) increase in that rate by about 1% per year until reaching a terminal rate near 3.5% in 2018. This marks the end of seven years of ZIRP (Zero Interest Rate Policy) and is the first rate hike in nine years. I wanted to take a minute to clarify how this move is likely to impact you. There is a perception that the Federal Reserve controls nearly all rates on all financial products, which is not the case. Below is a non-exhaustive list of what will likely be impacted immediately and over the longer term. As always, if you have questions about something that is or is not covered below, please don’t hesitate to ask.
· Interest Paid By Your Bank On Your Savings – Likely no impact at all in the short-term. The average checking account will still pay approximately 0.00%. The average savings account will still pay approximately 0.05%. Online savings banks, some credit unions, some local banks, etc. will continue to pay in the 0.5-0.9% range. It is very unlikely that the big banks (BoA, Wells, JPMorganChase, etc.) will raise their rates on savings as a result of the Fed hike. Once the Fed Funds rate gets to 0.75%-1.00%, we’re likely to see the big banks begin to pay more in interest and move rates up slightly less than 0.25% with every 0.25% hike by the Fed. While the banks get paid more on their reserves, they won’t really have an incentive to pass that along to the consumer until rates are a bit higher and they start competing over customers. This is akin to when oil prices come down suddenly, but prices at the gasoline pump move down much more slowly over an extended amount of time.
· 15 & 30 Year Fixed Mortgage Rates – Likely little impact in the short-term. Mortgage rates are tied to longer-term rates than the Fed Funds rate (which is an overnight lending rate). Long-Term rates are much more tied to the economy, the supply of and demand for money, competition with long-term rates in other countries, and expected long-term inflation than they are to the short-term rates that are controlled by the Fed. The Fed will move short-term rates up as the economy improves, so in a sense, long-term rates should come along for the ride over time as economic growth leads to higher inflation expectations and higher demand for money. In reality though, increasing short-term rates tends to put a brake on economic growth and given the extreme policies in Europe and Japan that are geared toward keeping long-term rates down in those countries, it’s unlikely that US long-term rates can move up very far very fast.
· Variable Loan Rates (mortgages & other) – Likely to move up in lock-step with the increase in Fed Funds. Most variable rate loans are tied to the PRIME rate (generally 3% above the Fed Funds rate and controlled by banks) or to 1-month, 3-month, or 1-year LIBOR (another short-term lending rate that is very closely tied to the Fed Funds rate plus a premium for credit conditions). The big banks increased their PRIME rate to 3.5% shortly after the Fed’s announcement today. LIBOR has been floating up in expectation of the Fed announcement. As an example, if you have a Home Equity Line Of Credit (HELOC) with a rate that is PRIME + 0.5%, you’ve been paying 3.75% interest on that loan for the past 7 years. As of today, that rate is now 4%. By the end of 2016 it is likely to be 5% and by 2018 it is likely to be 7% if Fed projections are correct. If you have a variable rate primary mortgage that is 1-year LIBOR + 2.75% rounded up to the nearest 1/8th of a percent, that rate was 3.375% a year ago and today it’s 3.875%. It would likely be ~5% by end of 2016 and ~7% by end of 2018 if Fed projections are correct. You can expect a point-for-point increase in the rate of loans tied to PRIME and a close to point-for-point increase in loans tied to LIBOR. LIBOR loans could also see additional increases if credit tightens (like it did in the extreme case in 2008/09 after Lehman Brothers failed and no one trusted lending money to anyone else for a while).
· Economic Growth – There is a school of thought that believes that ZIRP was hurting economic growth and causing dislocations through the financial system. The more traditional economic view is that the lower the Fed Funds rate, the more stimulative it is for growth. I personally believe that low rates are stimulative in that they encourage more borrowing, more lending, more spending, more investing, and less saving (cash sitting around doing nothing). However, the longer rates stay low, the more they push investors into riskier investments in seeking higher yields. This applies both to financial institutions (a SF Credit Union offered a $3M mortgage with no downpayment required last week, for example), and to individual investors putting money in high-yield investments without considering the risk (see this article from Bloomberg about a recent high-yield bond mutual fund that recently told investors they couldn’t sell and get their money back). Eventually, excessive risk-taking leads to a bubble which inevitably leads to a crash. So, in a sense, the Fed’s rate increase and guidance that they will continue to normalize rates helps to avert a growing bubble/crash scenario. Fear subsiding can lead to higher economic growth. Whether that is enough to offset the negative growth impact in reduced lending, borrowing, investing, and spending remains to be seen. A 0.5% Fed Funds rate and $4 Trillion Fed balance sheet are extremely stimulative. But with each increase in rates, and with each reduction in the size of that balance sheet (which will start eventually), they become a bit less stimulative. Economists generally believe that the level of rates and size of the balance sheet are more meaningful than the direction of movement in those rates and the balance sheet. The aggregate psychology of the financial markets seems to put more weight in the direction of movement. I suspect that short-term, the markets will have their way and price in a slowdown in growth, some of which has already started. The Fed’s challenge is that if markets believe higher rates will cause a recession, that belief alone can cause the recession as businesses pull back investment, consumers slow their spending, layoffs start, etc. It remains to be seen whether the Fed can maintain confidence via a very slow trajectory of rate hikes, in which case they’ll be able to normalize rates over time while continuing to let low rates stimulate growth during the rate hike cycle.
· Inflation – Inflation is currently running near zero year over year, mostly due to the impact of the sharp decline in commodity prices. This has run counter to everything in economics textbooks. Central banks all over the world have been printing money to try to stimulate growth and avoid deflation. Even with trillions more dollars, euros, and yen in the system, the aggregate price of goods is not rising. The Fed believes the impact of energy is “transitory” in that lower energy prices tend to feed through the economy short-term and hold inflation down, but over the long-term lower energy prices provide an engine for growth. They believe inflation will get back to their target, which is 2% per year, over the next few years. They say they’re increasing interest rates starting now so that they can do it in a gradual manner rather than waiting until inflation picks up which would cause them to move more aggressively with rate hikes to fend off a hyperinflation scenario (which has caused recessions in the past). Again, it remains to be seen whether they’ll be successful or not.
· US Dollar Relative To Foreign Currencies – The dollar has been on a big run relative to other currencies since mid-2014. Money usually chases higher rates and safety (which rarely go hand-in-hand). In this case, the US looks safer than virtually any other country (some plagued by political instability, others by a banking crisis, others by fiscal issues), and it had the prospects of increasing rates over time while other major parts of the world are decreasing rates and/or printing money to fend off recession. Higher US interest rates are widely expected to continue to increase the dollar’s value relative to other currencies. At some point though (and maybe it’s here), a higher dollar starts to impact US exports substantially, starts to push more work offshore where labor is cheaper, and starts to make foreign investments look cheap in dollar terms while US investments look expensive in foreign currency terms. All of those things can put a dent in US growth and cause interest rates (and therefore the dollar) to come down. There’s no way to know what’s going to happen, but it definitely feels like the dollar is getting very expensive and foreign currencies (particularly those of emerging markets) are getting very cheap. One thing is certain… if you live in the US, are paid in US dollars, and like to travel the globe, it’s a LOT cheaper to do it today than it was a couple of years ago.