After much agonizing, and following years of rumored increases, the Federal Reserve Board (the Fed) announced its first interest rate hike since 2006 in mid-December. Their rationale for the 25 basis point bump (.25%) is that the economy, after 6 years of a comparatively weak recovery, is finally sound enough to weather the increase without coming off the rails. This is anticipated to be just the first of several small rate increases over the next two years, similar to Fed moves between 2004-2006. The increase will be closely watched by worldwide analysts as the European Central Bank and the People’s Bank of China are moving in the opposite direction to try to stimulate a recovery that is sputtering in foreign markets.
But what will it do to us at home, and specifically to your pocketbook, since that’s what really matters? Well, on a positive note, few believe this increase will cause an immediate or deleterious impact to consumers. Technically the Fed rate only impacts the rate the Fed loans money to banks, not to consumer loans. However, within minutes of the Fed’s decision, Wells Fargo, JPMorgan Chase and US Bancorp became the first banks to announce that they would increase their prime rate, a rate used for consumer loans like mortgages, credit card and auto loans. Effective December 17, the prime rate at Wells, JPM and US Bancorp moved from 3.25% to 3.5%. Later in the afternoon, Citibank announced a similar move; many other banks are likely to follow suit. And while the banks announced the immediate hike in interest rate, they did not announce a corresponding hike in savings or deposit rates, preferring to increase the slim margins they’ve been experiencing on their portfolios the past few years.
The goal of this move, as with most Fed policy, is to move the economy toward ‘normal’, whatever that is. Changes in interest rates can have both positive and negative effects on the U.S. markets.
When the Fed changes the rate at which banks borrow money, this has a ripple effect across the entire economy. By raising and lowering the federal funds rate, the Fed can prevent runaway inflation and lessen the severity of recessions. While rising or falling interest rates do affect consumer and business loans, it is important to understand that there is generally a 12-month lag in the economy, meaning that it will take at least 12 months for the effects of any increase or decrease in interest rates to be felt. By adjusting the federal funds rate, the Fed helps keep the economy in balance over the long term.
Hopefully. That micromanagement of the economy doesn’t always work successfully and has been blamed, in some part, for the financial meltdown in 2007-2008.
Indeed after two days of celebrating the increase as a sign of a strengthening economy, investors sent stocks plummeting in their worst day in weeks after realizing that global growth is likely to slow even further amid concerns about the impact to consumers and companies. For example, consumers will likely see an increase in their credit cards and home equity lines of credit within a couple billing cycles meaning a few less dollars to spend elsewhere. And while it means good news for Americans traveling overseas, it also means bad news for American manufacturers in the export market, undermining our trade balance.
As the Fed continues to raise rates over the next couple years, this will ripple through the entire economy impacting everything from mortgage rates to corporate bonds. Many analysts are forecasting a rise in mortgage rates into the 5.5% – 6% range by 2017 and credit card rates from 15% to 17%. Moody’s Analytics expects the increase could curtail economic growth and slow monthly job gains by 30,000.
Along with the rest of us, Fed policymakers stressed in their announcement that they will closely monitor the impacts of these small, gradual increments and stand ready to pull back if the economy falters. That can be difficult since higher interest rates don’t always bite in predictable ways as they percolate through the real economy. Economists warn that there is a very difficult-to-foresee threshold at which the impact can shift from mild to severe with frightening intensity.
Somewhere between ‘irrational exuberance’ and ‘undue pessimism’ lies the hoped for outcome of Fed policy perhaps best summed up by Scott Anderson, chief economist at Bank of the West in San Francisco. Anderson expects the economy to continue to grow at a moderate annual pace of about 2.4 percent in 2016. “Consumers are cautious but they still have the capacity to spend,” according to Anderson. “Jobs and incomes are growing, debt levels are low and gas at about $2 a gallon should help. When people realize the sky isn’t falling because the Fed is raising rates, they will go back to their usual spending habits and save the day.”