Interest rates play a crucial role in the American economic system. They influence the return on savings, the costs of borrowing and can have a bearing on the direction of many investments. The direction of interest rates is also known to provide insight into future economic and financial market activities.
After the Federal Reserve’s August 2021 meeting, Fed Chairman Jerome Powell stated that, should hiring numbers continue to improve, it will begin dialing back the ultra-low interest rate policies that were put in place to help stave off the effects of the pandemic-induced recession. In an effort to encourage borrowing and spending, the Fed has been buying $120 billion worth of mortgage and Treasury bonds per month. Short-term interest rates were also decreased to near zero to spur consumer spending, encourage hiring, and keep investors in the stock market.
Powell stated that the Fed will begin “tapering” off the bond buying program. “Tapering” refers to the gradual, not sudden, decrease in the Fed’s purchases. This is done in an effort to progressively remove monetary stimulus from the economy.
Powell stressed that this action does not mean an interest rate hike would shortly follow. Many variables, including the recent increase in Covid cases, are being watched and considered in any moves the Federal Reserve decides to take.
“The timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest-rate liftoff, for which we have articulated a different and substantially more stringent test,” Powell said.
He continued, “We have said that we will continue to hold the target range for the federal funds rate at its current level until the economy reaches conditions consistent with maximum employment, and inflation has reached 2% and is on track to moderately exceed 2% for some time. We have much ground to cover to reach maximum employment, and time will tell whether we have reached 2% inflation on a sustainable basis.”
Here are a few major areas that interest rates could have a positive or negative impact.
Savings accounts
A rise in interest rates could be favorable for savings account and certificate of deposits (CDs) holders. While rates are still very low, if interest rates rise, the yields on these accounts typically increase.
Bond holdings
With the economy continuing to strengthen and unemployment numbers decreasing, most Fed officials are expecting the Fed to reduce bond purchases this year. What exactly does this mean for bond holders and purchasers?
As you many know, bond and interest rates move in the opposite direction. When interest rates rise, existing bond prices tend to fall, and conversely, when interest rates decline, existing bond prices tend to rise. As interest rates rise, new bond yields are likely to change.
Investments
Converse to bonds, interest rates don’t directly affect stocks. They can, however, indirectly affect stock prices. When interest rates rise, banks increase their rates for consumer and business loans. Reduced consumer and business spending could lower the value of a stock. When interest rates are increased, this usually means that there is economic growth or strengthening.
Portfolios that are well balanced, diversified, and planned to weather volatility should be well positioned to face rising interest rates.