Federal Reserve: How It Effects Interest Rates

Well, the Fed finally raised short-term interest rates last week after eight years at or near zero. This was possibly the most anticipated and telegraphed change to interest rates in the history of the Federal Reserve. The predictability of the move may be the reason why markets took it in stride. The stock market typically does not like rising rates, which are thought to slow economic activity. The increase from the Fed only affects the Federal Funds Rate, which is the overnight rate that banking institutions charge each other. Banks loan each other money when one bank does not have enough reserves and another bank has a surplus. The reserves are held by the Fed, and the rate charge on the loan is in the range established by the Fed Funds rate.

The Federal Reserve only raised the Fed Funds rate by .25%, from a range of (0-.25%) to (.25% – .50%). The move signaled that the U.S. economy has largely recovered from the financial crisis of 2007 – 2009, and the Fed believes that the economy is now strong enough to withstand slightly higher rates. This is akin to someone who had knee replacement surgery giving up his crutches. It may be a bit harder to walk at first, but it’s an important part of the healing process and getting back to normal.

“What impact will the Federal Reserve’s rate increase have on me?”:

1)   Money Market / Savings Accounts:

Short term savings vehicles have been yielding very close to zero for several years. Unfortunately, most savings accounts and money market funds will raise their interest rates by less than the .25% increase that the Fed announced. Many of these funds reduced their fees in order to keep their yields positive over the past several years. Money market funds (asset managers) from Schwab to Federated have waived over $30 billion in fees from 2009 – 2014.The increase in the Federal Funds rate will enable some of these funds to increase their fees back to (or close to) their normal levels. Some funds, which had low fees to begin with, did not need to reduce their fees and may be able to pass on the full .25% increase. That will take a few months to materialize.

2)  Home Equity Lines of Credit:

HELOC payments will increase slightly for millions of Americans almost immediately. These loans typically carry an interest rate of Prime plus a Margin. The Prime Rate is approximately 300 basis points (3%) above the Federal Funds rate. This means that the recent increase in the Federal Funds rate raised Prime from 3.25% to 3.5%.

3)  Mortgages, Autos and Consumer loans:

The interest rates on these loans are based largely on U.S. Government bond yields. The most widely followed and influential is the 10 year U.S. Treasury. Bond yields are not set by, or controlled by the Federal Reserve. They are determined by the supply and demand for bonds among investors. Many people are surprised that U.S. Government bond yields have decreased slightly since the Fed’s announcement. There are a variety of reasons for this, but the bottom line is many investors are still buying (or increasing their purchases) of U.S. government bonds because they are still considered among the safest investments in the world. This means that mortgage rates actually declined very slightly over the past week. Eventually, they are likely to rise, but how much and when remains to be seen.

Overall, interest rates remain very low by historical standards. Future increases are expected to be made slowly as the economy shows that it can handle higher (normal) rates. As rates rise, certain asset classes are more vulnerable than others (bonds, dividend paying stocks, real estate investment trusts), and you may want to reevaluate your portfolio in the future if interest rates continue to rise. For now, we do not expect any major fallout from the Federal Reserve’s small and gradual rate increases.