Over the past year, we have all seen the economy heat up, unemployment rates drop and prices rise due to increased demand. As a result, the Federal Reserve has signaled that after keeping interest rates low for over 20 years, it is time to move them in the opposite direction. The past four Federal Reserve Chairs each said during their term in office, the time was not right to raise rates back then. However, with inflation rising today at a pace not seen in 40 years, it appears the Fed currently has no choice but to take their thumb off the scale.
While this is a standard course of action as higher interest rates are a lever that the Federal Reserve can use to cool down a hot economy, it’s been a long time since it’s been implemented with any degree of seriousness.
We can all agree that a strong economy is a good thing, it can however, lead to a higher rate of inflation, with the possibility of hyperinflation. Long story short, while a low to moderate level of inflation can be positive and is typically what the Fed strives for, higher or hyperinflation can be very detrimental as the value of a dollar is quickly eroded by rising prices.
What happens when interest rates go up?
As the Federal Reserve looks to raise interest rates, there are some unique consequences to prepare for.
- Bond prices go down.
Bond prices and interest rates are negatively correlated, meaning when interest rates rise, the prices of existing bond prices go in the opposite direction, and vice versa. This is because bonds have a fixed interest rate. As current interest rates move up, new bonds are typically issued with higher rates and as such, are more attractive relative to previously issued bonds. In essence, previously issued bonds “trade” at a discount to newer bonds with higher rates.
Therefore, it’s likely that investors will see the current value of their bond holdings decrease as interest rates go up. They still, however, will collect the interest payments at whatever rate the bond was issued at. Additionally, it is important to keep in mind that when a bond matures or if it is called, in almost all instances, the bondholder receives the face amount of the bond.
As bond prices fluctuate, it may be a good time for investors to identify opportunities to swap out bonds and rebalance their holdings, making sure that they are maintaining their desired risk level based on their goals and timeline.
- Debt becomes more expensive.
As interest rates go up, business loans, credit card rates, and even home mortgages can become more expensive. In addition, for individuals or businesses with variable rate debt, their interest rates adjust as interest rates rise, making it challenging to maintain or service their existing debt. This can lead to defaults if people cannot afford to make their higher debt payments.
In addition, as people shop for new debt, such as a mortgage for a new home purchase, they are finding that mortgage rates have gone up, reducing their overall purchasing power as their mortgage payments will be higher. There is evidence that home buyers who are already in the market for a home, are speeding up the process to buy sooner.
For businesses, higher costs associated with debt can lead to less growth as companies are constrained by increased debt payments and may not be interested in expanding operations because of the resulting higher debt costs that may come with it.
- Savers can be rewarded.
The flip side of more expensive debt is that savers are often rewarded with higher interest earnings on their savings. Everything from high yield savings to money market accounts may offer higher interest rates, creating an incentive for individuals and businesses to park their cash and earn a higher yield.
This may provide some relief for savers, after suffering through next-to-zero interest rates for the past few years.
- The economy can cool down.
As interest rates rise, causing debt to become more expensive and saving to become more advantageous, both individuals and businesses often cut spending to accommodate this new landscape. Ultimately, this can lead to a cooling off of the economy as revenue and growth projections are cut to account for higher savings and lower spending.
While this is often the goal when raising interest rates, there is a fine line between cooling down a hot economy and actually cutting growth. On the one hand, it is essential to curb inflation and maintain the value of each dollar relative to the goods and services it can buy. Still, it’s also necessary to have a steady demand for those goods and services in the form of consumer spending. If demand falls too fast or servicing debt becomes too expensive, it can trigger a recession, as businesses experience decreased revenues, and individuals and companies struggle with their debt.
What to expect going forward.
Unfortunately, the economy hasn’t been in a rising interest rate environment for a long time, so it is difficult to say what the near-term future may hold. That said, it is reasonable to expect some turbulence as interest rates rise and individuals and businesses go through an adjustment period.
For investors, they can expect a decrease in the value of their bond accounts as interest rates rise, causing previously issued bonds to be currently valued at a discount. It can be an excellent time for those approaching or already in their work-free years to review their financial plan, understand their risk tolerance, and ensure their investment portfolio matches their desired risk tolerance.
An essential way to ensure long-term success is knowing your plan and sticking with it during difficult or turbulent times. The biggest thing to avoid is making panicked decisions with your finances at inopportune times.
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As a CFP® professional since 1985, I have experienced times of rising and falling interest rates, several major bear markets and many geopolitical events that shook the world and the financial markets. I use my three and a half decades of experience to help clients transition into and make the most of their work-free years. My work centers around helping you maximize the enjoyment you receive from your money, all while creating a financial plan that works and is built to last.
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