The Federal Reserve raised interest rates for the first time in nearly a decade. Hark! The herald angels sing, “Glory to the higher yields Fed chair Janet Yellen will bring.”
In a move precipitated by an improving job market and decent economic growth, the Federal Open Markets Committee decided to raise short-term rates by a quarter of a percentage point from basically zero.
That’s where the bellwether Federal Funds rate, which is what banks charge one another on overnight loans, has stood for seven years. The last time the Fed increased borrowing costs was before the start of the global financial crisis in 2006, at the start of George W. Bush’s second term.
“Given the economic outlook, and recognizing the time it takes for policy actions to affect future economic outcomes, the Committee decided to raise the target range for the federal funds rate to 1/4 to 1/2 percent,” the FOMC said today.
Today’s move follows months of speculation about when the central bank would act, especially following the Fed’s decision in September to leave rates untouched amid concerns over the strength of the global economy.
Here at home, though, the nation’s employment picture has markedly improved over the past three months, with monthly job gains averaging 218,000. And the so-called core CPI inflation rate, which strips out volatile food and energy prices, hit 2% in November.
While the Fed feels the pressure to raise rates to historically normal levels, it doesn’t have to do so at an accelerated pace. In a speech earlier this month, Fed Chair Janet Yellen warned that “an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession.”
“This interest rate hike is the first element of what is likely to be a very shallow path that would end up constituting the ‘loosest tightening’ in the modern history of the Fed,” says Allianz chief economic adviser Mohamed A. El Erian. “When the Fed completes the cycle, the policy rate will be below historical averages.”
But as with any economic development, there are winners and losers.
IF YOU’RE A BOND FUND INVESTOR…
Rising interest rates are a risk for any investor who owns shares of a bond mutual fund or ETF. The reason: Bond prices fall when market rates rise.
To find out how much your bond fund is likely to drop in price, you can look up the fund’s “duration”. This figure (which you can check at Morningstar.com) reflects how sensitive a bond fund is to interest rate fluctuations. So Vanguard Total Bond Fund, with an average duration of 5.7, would fall about 5.7% with a 1% increase.
But as Chris Cook, president of Beacon Capital Management, told Money’s Carla Fried, bond fund owners aren’t in for that big a scare in this type of rate environment.
“The majority of your total return comes from the yield, not price changes,” says Cook. “Your rising income payouts will soon make up for any price drops.”
Also keep in mind that the Fed only set the yields on short-term borrowing costs, not on long-term yields. One scenario is that “the Fed raises short rates, yet there’s no sign of inflation,” which affects long rates, says Mark Luschini, strategist for Janney Montgomery Scott. If that happens, demand for longer-term bonds could rise, actually pushing long-term prices higher despite the rate hike.
Finally, remember that you don’t invest in bonds simply for high returns, notes Gregg Fisher, chief investment officer of Gerstein Fisher, but rather as a ballast in volatile times. When stocks fell more than 50% during the great recession, short-term Treasuries increased by 9%.
IF YOU’RE A SAVER…
Savers have endured a miserable time ever since the Great Recession. In Money’s Best Banks package, we found that the average brick-and-mortar savings account yields only 0.08% interest on a $10,000 balance — or $8 bucks a year. So higher borrowing costs should provide a salve.
“We view the Federal Reserve’s decision as an unequivocal positive for both long-term investors and for savers,” says Vanguard.
Unfortunately banks take eight months, on average, to increase interest on a money market account following a Federal Reserve hike and 14 months for interest checking, per a 2013 Fed study. Nevertheless, expect your CDs and savings accounts to do add more to your wealth over the next couple of years.
IF YOU’RE A BORROWER…
Those who plan to borrow money, say for a home or auto loan, theoretically should be less happy about the move. Higher interest rates means the cost of financing a loan will increase. The average 30-year fixed rate loan comes with a 3.9% in November, per Freddie Mac, compared to 6.2% in six years earlier.
“Mortgage rates remain very affordable by historical norms,” says Chris Heller, chief executive of Keller Williams.
Despite all of the Sturm Und Drang about today’s announcement, the amount you pay for most of your loans shouldn’t really change.
“A rate hike will mean higher earnings on savings and higher interest charges on loans — however expected changes have already been accounted for in most loans,” says NerdWallet’s Sean McQuay. “As a result, mortgage, student, and auto loan rates should remain largely the same.”
Those who carry a balance on their credit cards, however, might feel a bit more pain, although not much more. NerdWallet estimates that the average indebted household, which carries more than $15,000 in debt, will have to pay $125 more in interest payments over the next five years.