What an Interest Rate Increase May Mean for You

The Federal Reserve, which sets short-term interest rates, is set to increase those rates tomorrow for the first time in a long time. Without getting into the specifics of the complex considerations that go into this decision, let’s take a look at what’s behind the likely action and what it may mean for your investment returns, mortgage rates, and the overall economy.

Why is this happening now?

Since the recession of 2008 and 2009, the economy has been in the process of a halting, at times painfully slow recovery. The Fed has kept the cost of borrowing money—the short-term interest rate—as low as possible to encourage entrepreneurs and those seeking loans to do so with as little penalty as possible. This is seen by many economic experts as a way to drive economic growth. A recent jobs report indicates that unemployment is steadily decreasing, prompting the Fed to remove what has essentially worked as an economic stimulus and move to a more neutral stance, assuming that the recent momentum will continue.

What will this mean for me?

The change in short-term interest rates is unlikely to have a huge impact on most individual investors. The rate of borrowing for auto loans, for example, will likely increase a bit, but so will the interest paid for savings and interest-bearing checking accounts. But keep in mind that a small increase in short-term rates, which this is expected to be, will still leave rates at historically low levels.

The most likely impact of the policy change is some immediate market volatility—big swings in stock indexes such as the Dow Jones Industrial Average and the NASDAQ, for example. For long-term investors, these reverberations are like pebbles tossed into a river; they aren’t going to—and shouldn’t—divert your long-term investment strategy.

In fact, historically, these short-term fluctuations after a Fed adjustment have led stock values to trend higher. Economists argue about the relationship of cause and effect here, but many agree that this rise is due in part to the overall strength in the economy that leads to the increase in short-term rates. As always, past performance doesn’t guarantee that stocks will perform the same this time around; it is, after all, in the past. But it does serve as a general indicator that has remained pretty tried and true over decades of economic cycles.

Bond prices, on the other hand, tend to be pushed lower by increases in short-term interest rates. But not all bonds react to interest rate shifts in the same way. If you’re heavily invested in bonds or are getting close to retirement, you’ll want to talk to your advisor about the historic performance of municipal versus corporate bonds, stable versus high-yield bonds, and treasury or mortgage-backed bonds. For those already in retirement or receiving annuity income, there may be more substantial impacts on payments, particularly for variable annuities or new annuitants.

In brief, this coming shift in short-term interest rates will not be drastic and shouldn’t substantially alter the long-term plans of most investors. Don’t overreact to the shift or to any short-term market volatility. As we’ve discussed previously, timing the market is a terrible investment “strategy” for the vast majority of investors.

Image (cropped) by Day Donaldson/Used with Creative Commons License 2.0.