The Fed Is Raising Rates

The investment community in obsessed with interest rates.   We regularly hear about the Federal Reserve Board (aka The Fed) “raising rates”, referring to the federal funds rate. This is the interest rate that banks charge each other to borrow or lend money.  And the fed funds rate largely determines the “prime rate”, which is what the banks charge their best customers.  Prime rates largely drive mortgage rates, credit card rates, and other consumer and business loan rates.   Indeed, the Fed funds rate has a ripple effect throughout the economy.   If the rate goes up on an individual or business loan, the cost of that loan goes up and there are fewer dollars in the pot to spend.  Less spending means fewer sales for corporations, less earnings, and potentially lower stock prices.   Businesses often have to borrow to expand or fund their operations – at higher rates they pay more or borrow less, potentially harming earnings and/or growth.

Higher interest rates also effect the bond markets.  Bonds are tricky when it comes to interest rates.  When rates go up, the price of a bond goes down.  What? Why is that? Well if a bond pays me a fixed dollar amount each year, and the market rate for that bond goes up, my bond must go down in value.   It’s an inverse relationship.  That’s why the bonds in our portfolios have gone down in value this year; it’s because interest rates have gone up.  The average bond (the Aggregate Bond Index) has dropped in value by 2 ½ percent this year.  Companies often raise capital to pay for expansion by issuing bonds.  To attract new money, corporations (and the US government, btw) will have to pay higher interest, increasing their costs.

So why would the Fed want to raise rates?  The Federal Reserve has two purposes:  full employment and stable inflation.  They achieve these mandates, in part, by raising or lowering the Fed funds rate.  Check the box for maximum employment.  Their second mandate is to contain inflation. A strong economy and the resulting increase in demand causes prices to go up.  One contributing factor is labor costs.  Companies can’t find good workers to fill job openings, resulting in the need to pay more in salaries and benefits, and pass on their higher costs in the price of goods and services.

Typically recessions occur because the Fed overdoes it – they raise rates too much and too often in an attempt to cool down a hot economy.  We all remember how ugly the GREAT RECESSION was in 2008 and 2009.  Is it time to tuck tail and bail?  NO. Inflation is still low by historic standards, just now approaching the Feds goal of 2% per year.  The US economy is estimated to grow by 2.9% this year (The Kiplinger Letter) – certainly not excessive. Businesses are reporting higher profits and the fully employed population is making more and spending more.  All good things.  The Fed Funds rate is currently 1.5% with a long term average is 4.84%.  Still very low. So it’s important to pay attention, but we’re nowhere near the third story window. 

We recommend staying the course with a disciplined long term investment plan and we appreciate our loyal clients and friends.

-Wade

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