Fed Raised Interest Rates and Two More Coming in 2019 – How Are We All Affected?
The Federal Reserve upped its target range by another 25 basis points to between 2.25 percent and 2.5 percent, and Central bank officials now forecast two more quarter-point rate hikes next year, per CNBC report.
While the Federal Reserve continues to include in its statements that further “gradual” rate hikes would be appropriate, the GDP (Gross Domestic Product) is now seen as rising 3 percent for the full year of 2018.
What’s GDP again?
It is a monetary measure of the market value of all the final goods and services produced in a period of time, often annually or quarterly. Nominal GDP estimates are commonly used to determine the economic performance of a whole country or region, and to make international comparisons.
Image courtesy of Adam Smith Institute
The Fed dropped the benchmark rate a total of five percentage points between August of 2007 and the end of 2008 – a move which helped drive the 30-year mortgage rate down to an all-time low of 3.31 percent in 2012.
The Fed has since raised its target by a total of 2.25 percent and the benchmark mortgage rate is back up to 4.63 percent, which remains two full percentage points below average as measured over the past 30 years.
Photo: Benchmark Mortgage Rate Drops to a Three-Month Low graph courtesy of SocketSite
What are the impacts of the Fed raising the rates?
When interest rates increase, consumers and businesses feel the real-world effects of how they can access credit to make their necessary purchases and plan their finances. To put simply, consumers will pay more for the capital required to make their purchases, and businesses will face higher costs tied to expanding their operations and funding payrolls. The borrowing costs for everybody are higher.
The Prime Rate
The prime rate represents the credit rate that banks extend to their most credit-worthy customers. This rate is the one on which other forms of consumer credit are based, as a higher prime rate means that banks will increase fixed, and variable-rate borrowing costs when assessing risk on less credit-worthy companies and consumers.
Credit Card Rates
Working off the prime rate, banks will determine how credit-worthy other individuals are based on their risk profile. Rates will be affected for credit cards and other loans as both require extensive risk-profiling of consumers seeking credit to make purchases. Short-term borrowing will have higher rates than those considered long-term.
Money market and credit-deposit (CD) rates increase due to the tick up of the prime rate. In theory, that should boost savings among consumers and businesses as they can generate a higher return on their savings. However, it is possible that anyone with a debt burden would seek to pay off their financial obligations to offset higher variable rates tied to credit cards, home loans, or other debt instruments.
U.S. National Debt
A hike in interest rates boosts the borrowing costs for the U.S. government and fuel an increase in the national debt. A report from 2015 by the Congressional Budget Office and Dean Baker, a director at the Center for Economic and Policy Research in Washington, estimates that the U.S. government may end up paying $2.9 trillion more over the next decade due to increases in the interest rate, than it would have if the rates had stayed near zero.
Auto Loan Rates
Auto companies have benefited immensely from the Fed’s zero-interest-rate policy, but rising benchmark rates will have an incremental impact. Surprisingly, auto loans have not shifted much since the Federal Reserve’s announcement because they are long-term loans.
A sign of a rate hike can send home borrowers rushing to close on a deal for a fixed loan rate on a new home. However, mortgage rates traditionally fluctuate more in tandem with the yield of domestic 10-year Treasury notes, which are largely affected by inflation rates.
When interest rates rise, that’s typically good news for the profitability of the banking sector, as noted by investment giant Goldman Sachs. But for the rest of the global business sector, a rate hike carves into profitability. That’s because the cost of capital required to expand goes higher. That could be terrible news for a market that is currently in an earnings recession.
Higher interest rates and higher inflation typically cool demand in the housing sector. On a 30-year loan at 4.65%, home buyers can currently anticipate at least 60% in interest payments over the duration of their investment. Any uptick is surely a deterrent to acquiring the long-term investment former President George Bush once described as central to “The American Dream.”
Photo: US News & World Report
A rise in borrowing costs traditionally weighs on consumer spending. Both higher credit card rates and higher savings rates due to better bank rates provide fuel a downturn in consumer impulse purchasing.
Any good news?
There are stocks that perform best when interest rates rise
Photo: The Motley Fool
Although profitability on a broader scale can slip when interest rates rise, an uptick is typically good for companies that do the bulk of their business in the United States. That is because local products become more attractive due to the stronger U.S. dollar. That rising dollar has a negative effect on companies that do a significant amount of business on the international markets.
As the U.S. dollar rises – bolstered by higher interest rates – against foreign currencies, companies abroad see their sales decline in real terms. Companies like Microsoft Corporation (MSFT), Hershey (HSY), Caterpillar (CAT), and Johnson&Johnson (JNJ) have all at one point warned about the impact of the rising dollar on their profitability.
Rate hikes are particularly positive for the financial sector – the banks!
The banking sector’s profitability increases with interest rate hikes because institutions in the banking sector such as retail banks, commercial banks, investment banks, insurance companies and brokerages have massive cash holdings due to customer balances and business activities.
Photo: Finance Monthly
Increases in the interest rate directly increase the yield on this cash, and the proceeds go directly to earnings. An analogous situation is when the price of oil rises for oil drillers. The benefit of higher interest rates is most notable for brokerages, commercial banks and regional banks.
How exactly do they make a profit?
In short, these companies hold their customers’ cash in accounts that pay out set interest rates below short-term rates. They profit off of the marginal difference between the yield they generate with this cash invested in short-term notes and the interest they pay out to customers. When rates rise, this spread increases, with extra income going straight to earnings.