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Key Takeaways
If you’ve been paying attention to the news lately, you know that interest rates are rising. But you might still be curious to know why this is happening and who has the power to set our rates.
In short, it’s the Federal Reserve that has the ability to change interest rates in the United States.
Increasing or decreasing rates don’t only impact the cost of borrowing money for you, it has a much broader impact across the whole economy. Here is more about interest rates, why they are going up, and their effect on investors.
Interest rates are the expense associated with borrowing money. The Federal Reserve has the most influence over interest rates. They set benchmark interest rates that banks charge to lend and borrow money.
It’s important to understand this does not mean the benchmark rate is the rate you pay when you borrow money. There are many other factors at play that determine the interest rate you pay. For example, most lenders will review your credit history and current credit score to determine the appropriate interest rate to charge an individual. When lending money to businesses, lenders will look at the company’s creditworthiness, including its balance sheet and income statement.
Rising interest rates reflect an effort to combat inflation.
Increasing interest rates initiate a series of events. When interest rates go up, banks raise their interest rates on most loan types including mortgages, auto loans, and credit cards. A higher interest rate discourages people from borrowing money because it will cost them more. The result is people purchase fewer goods, leading to less demand. This, in turn, slows down business growth and the economy as a whole.
It is also essential to know that interest rates on savings products, like savings accounts, certificates of deposit (CODs), and fixed-income securities, also rise. This encourages people to save more money, which also helps to slow down an ever-speeding economy.
In essence, higher interest rates reduce economic activity and expansion, which curbs demand and promotes saving.
Benchmark interest rates establish the rate of interest on all types of debt, including corporate debt, loans, and the rate at which banks lend to one another.
Two of the most widely recognized benchmark interest rates are:
The effective federal fund’s rate is also known as the target interest rate. This is the interest rate at which banks borrow from or lend to one another overnight. The Federal Open Market Committee (FOMC) decides the objective for this benchmark rate. It moves the rate up or down to the target level, specifying a range between a maximum and minimum value.
The federal funds rate is important to the U.S. economy because it is a powerful tool the Federal Reserve uses to impact monetary policy. By raising or lowering this rate, demand for goods and services will slow down or speed up in our economy, especially here at home.
The London Interbank Offered Rate, also known as LIBOR, is a key interest rate that serves as a benchmark in worldwide money markets for short-term loans. It performs the function of an internationally recognized target rate of interest that represents the costs of borrowing among banks.
The LIBOR rate is the median rate of interest at which the world’s largest banks borrow money from other banks. It serves seven maturity periods and is based upon five currencies, resulting in 35 different LIBOR rates.
Every day, the largest banks in the world enter the interest rates they would impose on other financial institutions for loans. The Intercontinental Exchange uses a trimmed average method to compute a benchmark rate, discarding the top and bottom figures and then calculating the average using the remaining numbers.
Once the rates have been determined and confirmed for each term and currency, they are declared and posted – daily.
In recent years, the LIBOR rate has been subject to manipulation and scandals and, as a result, is not regarded as highly as in years past. Because of these issues, the Secured Overnight Financing Rate will replace the LIBOR rate in June 2023.
Interest rates are rising right now because inflation is surging, not just in the U.S. but globally. There are many reasons for this, including government spending, stimulus money, supply chain issues, and cheap money in the form of low interest rates (until recently).
The Federal Reserve is aggressively increasing interest rates to slow the economy down. In 2022, the Fed raised interest rates 200 basis points, or 2%, in hopes of slowing down inflation. However, experts disagree on what effect it is having.
The Consumer Price Index peaked in June at 9.1% before falling slightly to 8.5% in July. The decline, though, was due to a drop in oil prices. Rent and food prices were higher in the July report than in the June CPI report.
Because inflation is holding firm, the Fed has stated it will continue to raise interest rates aggressively.
Higher interest rates affect investors in many ways. Here is a breakdown of how different investors will feel the impact of rising interest rates.
The stock market usually falls as interest rates rise. This is because investors flee from the higher risk of the stock market and invest in the fixed-income market since they can get a decent return with less risk.
While it costs more money to borrow, companies grow slower, so stock prices won’t rise as much, limiting investor returns.
The hardest hit stocks when this happens are high-growth stocks. This includes small companies and technology stocks since they tend to borrow a lot of money to fuel their growth.
On the other hand, large stable companies tend to fare better when the stock market falls. This isn’t to say these stocks don’t drop in value, but they tend to fall less than growth stocks. For example, stocks that pay dividends can withstand a drop in the market better than most other companies. This is because the dividend yield gets added to the expected return of the stock, increasing the overall return. Dividends are real returns that are all too often overlooked.
As for investing in fixed income, investors will jump to this sector since it is a safer alternative. The price of bonds does not reflect the future growth of the company that issued them, but rather the interest rate the bond pays.
This doesn’t mean investors will blindly invest in any bond during a rising rate environment. They will invest in shorter-term securities because these investments are less susceptible to interest rate risk.
For example, if you choose between a 30-year bond yielding 1% and a two-year bond yielding 4%, you will invest in the two-year bond. The 30-year bond seller will have to lower its price to compete with the shorter-term bond. This lower price will entice buyers to purchase the bond because not only will they earn the stated interest rate, but they will also experience a gain in the bond’s price when it matures. The end result will be the 30-year bond having an overall return that equals the yield of the 2-year bond.
The bottom line is during a rising interest rate environment, you want to invest in the shortest duration bond possible. This will allow you to limit losing money if you sell before the bond matures to purchase new, higher-rate bonds or swing back into more volatile investments.
Savers also benefit from higher interest rates because the interest rate on savings accounts and certificates of deposit will increase. In recent years, because interest rates were so low, many savers were forced to buy bonds and, in some cases, stocks to realize enough interest income for them to live.
Now that interest rates are rising, these people are taking their money out of stocks and bonds and putting it into the safer alternative of CDs.
Interest rates are going up because of the rise in inflation. The Federal Reserve raises interest rates to try to slow down economic growth, bringing inflation back to ideal levels. While many experts agree that rising interest rates are needed, there is disagreement over how long it will take to get inflation back under control. For this reason, investors should prepare to deal with higher inflation for the foreseeable future.
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