What Happens When the Fed Raises Interest Rates?

August 27, 2014

There has been endless speculation in the financial press recently over when the new Federal Reserve chairwoman, Janet Yellen, will reverse the course of the nation’s monetary policy and start raising interest rates and tightening credit.

The Chairwoman’s predecessor, Ben Bernanke, had famously introduced an easy money policy during the Great Recession starting in December 2008 by cutting rates and rolling out three consecutive programs of Treasury bond and mortgaged-backed securities purchases know as quantitative easing. Now that the US economy has started to return to normal, many are wondering what will happen when the Fed curtails its quantitative easing program.

At recent Fed meetings, the rates committee has stated that the Fed could start raising interest rates in 2015. Whether that happens in the first or second half of 2015 depends on how fast the economy recovers, when employment returns to pre-recession levels, and how fast inflation accelerates from its current low levels. A clearer indication of their intentions will emerge later in the fall after the Fed’s September and December meetings.

Always forward looking, the financial markets will anticipate the Fed’s actions and start to raise rates in anticipation of tighter monetary policy. Over the past few months mortgage rates have edged upwards and the stock markets have bounced around based on speculation over when the Fed will act. Anticipating tighter credit and higher rates, people have started to ask, “How will this affect me?”

Who are the winners and loser when rates rise?

Higher interest rates and tighter credit will create winners and losers as a result of the changes. Whether you are a winner or a loser under the new policy will depend in large part on whether you are a borrower or a lender.

Interest rates are basically a cost of money so some will pay more to borrow, while others benefit for earning more on their savings. Here’s some things to think about in order to best adapt to the rising interest rates.

Things that will be adversely affected

If you are a homeowner or about to buy a house, you will want to lock in the current low rates before mortgage rates increase. A 1% jump in a 30 year mortgage rates will increase your mortgage payment by 12% per month. If you plan on living in the house for a number of years, you will want to lock in that low rate for the longest period possible, so think about the 30 year amortization over shorter terms.

Home Equity Lines of Credit
These loans will have a floating interest rate that will rise with increasing rates. Check your loan documents to see what the benchmark rate is, how often, and how high it can rise. The increasing interest rate will require high monthly payments even if your loan balance does not increase.

House Prices
As mortgage rates rise, the cost of financing the purchase has two effects. Firstly, it drives some buyers out of the market because they cannot afford the payments. Secondly, it raises the monthly payments that potential buyers have to make. Both of these reduce the attractiveness of houses and reduce their selling prices.

Car Prices
Again, the costs of financing that big purchase will go up. Most people rely upon loans to finance their cars and with high rates, the monthly payments increase. This can be circumvented with longer term loans -- taking seven year loans instead of five -- or by leasing the car. Either way, the cost will increase.

Credit Cards
The effects with credit cards won’t be as noticeable. Most credit cards have rates based upon your credit scores and the rates are notoriously high. While some companies will use the high interest rate environment as an excuse to raise rates, the base rates were already high to start with.

Things that will be positively affected

Savings Accounts
Banks will finally start paying you interest on savings accounts. Rather than pennies a year the interest credited to your savings account will finally start to look like something worthwhile. Seeing a few dollars of interest accumulate in your savings account will be a nice reward for saving.

Bank CDs
Over the past six years, savers have received miniscule returns on their certificate of deposit rates at banks. This will change once the Fed starts raising rates -- banks will increase to rates they pay to depositors. Instead of taking the longer term certificate to enjoy the higher rates, savers should keep terms short to look towards rolling over their certificates at higher rates next time. This will be great for those who rely on the income from their savings.

When people retire and convert their savings into income annuities, they can enjoy a large stream of income at high interest rates. This is a huge benefit to savers who are looking to spend down their savings. If annuity rates increase by 1% from current levels, the amount of monthly income paid out increases by 12%.

Many financial commentators think that stocks will sell off as the Fed raises rates and tightens credit. Looking back at the last two times that the Fed changed course and started tightening, a counterintuitive response was observed in the markets.

The Fed increased rates from June 2004 through June 2006 and the S&P Equity index rose 9.4%. Similarly between May 1999 and December 2000 the Fed jacked up rates and the S&P index increased 10.2% the explanation proposed is that the Fed was raising rates to stem off an economic expansion and the equities enjoyed a nice appreciation due to a good business environment during those expansions.

So what can we expect when the Fed raises rates?

When the Fed finally starts to raise rates, it will be the end of the period referred to as Financial Repression. Borrowers will pay more and savers will receive more. Whether the rising rate environment is good or bad for you depends on where you are.