Interest Rate Hikes?
Yesterday, the Federal Reserve (“Fed”) has signaled two rate hikes, 0.25% each, in 2023. What are the implications of rate hikes on your financial investments and life overall?
To begin with, let us look into why the Fed is changing interest rates. In general, to stimulate economic growth in periods of slowdown or crisis the Fed lowers the interest rate to allow more money and credit into the system, which in turn encourages borrowing and investing. Likewise, at the beginning of the Covid-19 pandemic, the Fed took significant measures by dropping the interest rate to zero lower bound and purchasing multiple types of financial assets to keep the market stable. On the other hand, when there is too much accommodation and the economy is growing at a higher pace resulting in higher inflation and therefore lower purchasing power, the Fed would raise the interest rate to take money out of the system and return the economy to a more sustainable level of growth.
As a result of extraordinary fiscal and monetary policies that took place in 2020 and continue to influence the economy today, economic growth rebounded sharply. However, such measures resulted in higher-than-normal inflation. Still, economists are predicting that the recent increase in inflation is transitory, and we will return to a stable level of 2% by the end of 2021 and early 2022. Since the economy is expected to return to its typical condition, the Fed would start removing the accommodations it created by raising interest rates and shrinking its balance sheet, and it expects to start doing it in 2023.
So how it will impact your investments and life overall? From a short-term perspective, the Fed’s intentions are not making much of the difference in the short-term. Most likely it will add a layer of volatility to financial markets since rising interest rates decrease investment resulting in slower stock market growth. On the other hand, the bond market is going to start falling as investors would be looking to sell their fixed-income investments in anticipation of higher rates coming in the near future. However, it does not mean that the interest rate on your adjustable-rate loan or mortgage is going to rise significantly since these are controlled by the Fed and will stay in the Fed’s desired range until the interest rate will be changed. In terms of inflation, in the short-term it is unlikely to change since no money has been removed from the system, however, it will certainly start to impact inflation expectations and could potentially have some small impact on the actual level of inflation and economic growth. In short, you should not make any significant changes right now, but it is important to start thinking about what kind of asset allocations in your portfolio should be, when should you start rebalancing your portfolio, and how to get the most benefits from raising interest rates.
In the long run, things will start to change somewhat significantly. The pace of change will be slow, but the market will start pricing in the expected increase of interest rate in 2 years, which will positively or negatively affect certain sectors of the economy. Moreover, since the Fed is signaling about the rate hike you can start planning accordingly, adjusting your long-term plans and anticipated purchases. If you plan on purchasing a house or borrowing capital in 3 – 5 years you might rethink it since the rate is likely to be considerably higher than now. Overall, it is important to act accordingly since your portfolio and investment returns might change significantly in the long-term due to rising rates.
It is very important to keep an eye on your investments at any time, but especially in a period of rising interest rates, so any investor should start considering the implications of interest rate hikes on their portfolios.