The Fed’s Rate Hike explained

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Janet Yellen, chair of the U.S. Federal Reserve.

When the US economy crashed in 2007-09 following the sub-prime crisis, the banking system froze. The Fed brought its interest down to 0% and effectively ‘doped’ the economy for 8 years with very cheap money. This ended this Wednesday, the 16th, when the Fed increased its rate for the time since the crisis by a smallish 0.25%.

It looks like non-event and by itself it is. What is represents, however, is a big deal.

A sick patient

In the aftermath of 2007-09 and the collapse of Lehman Brothers, a huge issue of trust prevented the system from working properly. Banks would net lend money to each others, liquidity was missing and many businesses saw their lifeline cut. Bankruptcies followed, increasing the trust issue and re-inforcing the problem.

When businesses borrow money from the banks, the banks themselves get their borrowings from the Fed. The basic cost of borrowing comes from the interest rate the Fed applies on funds that the banks leave with the Fed overnight.

Technically, it’s the best and lowest interest rate available on the market so everything else is priced based on that rate: mortgage rates (eg. 30 years), car loans (eg. 5 years) and credit card rates (eg. 1 month). But savings rate (consumers lending to the bank) are also affected by this rate.

And a powerful medicine

Prior to the 2007-09 crisis, the Fed’s rate was set at 5.25%, meaning this was the cheapest rate at which the banks could borrow cash overnight. After the crisis started, to boost liquidity and promote lending, the Fed decreased its lending rate 10 times in 14 months to almost 0%.

This dramatic decrease remained within the 0% – 0.25% range for almost 6 years.

With all this cheap money and the subsequent Quantitative Easing, debt became very cheap and the housing market started to turn around. Companies borrowed at very low levels, regained confidence and started to hire again. Unemployment has fallen dramatically and companies are now making record profits.

Debt is so cheap that companies have started to borrow to buy-back their shares to boost EPS, pushing stock prices higher still. Awash with debt and equity, M&A deals have accelerated. Too much of a good thing can be dangerous and the Fed is also aware of that.

What comes down must go up

All this cheap money has been a boost to the economy and lowering interest rates is one of the easiest ways a central bank can control inflation and therefore growth. When the economy stalls, it lower the rates to stimulate it. When the economy overheats, it increases the rates to cool it down.

As long as the rates are set at 0%, the Fed doesn’t have much leverage to dope the economy again were it to go into recession again. Additionally, when rates remain low for a prolonged period of time, inflation expectations also go down towards deflation. Deflation becomes a problem when people and business stop spending in anticipation of future costs being lower than the current costs. Another vicious circle that feeds itself. This is why the Fed has a target inflation of around 2%.

Why it’s a big deal

An increase of Fed rate by 0.25% is by no mean going to impact your life or mine tomorrow. Maybe mortgage rate will go up a little and possibly the interest that we get on our savings account will start to increase next year. But other than, impact is negligible.

What will be visible to you and me and every consumer is what comes next.

According to the latest’s FOMC minutes, the Fed’s expectations are that rates will keep increasing for the next 3 years:

  • 2015: 0.4%
  • 2016: 1.4%
  • 2017: 2.6%
  • 2018: 3.4%

In 2018, mortgage rates could be around 7-8% again. House prices should come down as a result. Savings account may finally generate more than 0.1%, making people more wiling to save. Bond yields will increase and as the risk associated to a 5% return decreases, investment in stocks should decrease as well. Stock prices should then be expected to grow more slowly, or not grow at all.

Conclusion

So the rate hike that the Fed triggered this Wednesday is no big event in itself.

But the indication that it is on a path to raising rates back to normal levels over the next few years is a significant change.

Till then, many of us still have a Christmas celebration to prepare and gifts to buy wrap. Enjoy the good time with your friends and family. We are taking a 2-week break ourselves, starting this week-end and we will be back in January with lots of a good stuff. Stay tuned 🙂

Happy holidays everyone,

-Nick

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8 COMMENTS

  1. Nice summary of the impact of the interest rate change. I know that I worked with a lot of guys at my last company that were essentially still working because with low interest rates they had no reason to retire. They were waiting until interest rates started to rise again or something else happened to trigger their retirement.
    With interest rates now “on the rise”, maybe this will spur “the great crew change” everyone in the O&G industry has been blathering about since 2007 or sooner. I work with WAY too many people that complain about work, have 100% medical covered for retirement, and their retirement covered, and yet won’t retire because “why, I’ve got nothing better to do…” Ugh… No one accounted for people not retiring because they have nothing better to do, when predicting this crew change, lol.

    • I find it difficult to believe the folks who tell me that they’ve got nothing better to do. I mean , there are rare occasions where people have a real passion for their job and can keep at it until they can’t anymore.

      You might on to something here, because I can see this great crew change happening right now in my company. Not because of a rate increase but because of the low oil prices.

      Stay safe during the holidays and have a good time!

  2. You’ve written 2 posts about the bleak stock market in the near future, it sounds like you are pretty bearish on the stock market over the next 10 years. Do you plan to move your money to bonds?

    • You are correct, I have reallocated quite a bit of money away from stocks towards bonds and cash.
      Earlier this year, my portfolio was heavily invested in stocks (around 90%) and I readjusted to somewhere around 50%, so I am not out of the market.
      We have bought a house last month that we plan to turn into a rental property in the next 18-24 months. Real-estate in Texas currently has much higher return potential than equities, so this is something that I focus new investments on.
      This is also more capital intensive, so I have more cash available. If the stock market had to crash, I’d invest back into it but otherwise I am currently more interested in buying another rental next year.

  3. Good recap Nick, I’d argue that this is an even less of an event than you indicate because the trend started when they reduced QE. This is just a continuation of that trend, albeit a more visible one.

    I think 2018 will be a good time to buy, if the current trends increase, since home prices are more closely correlated to income than interest rates and a higher interest rate, assuming the same trends in income gains, would mean the demand side simply can’t afford to pay those higher prices.

    • Jim – you have some good points here. In some areas the real-estate market is already quite affordable, I’d be happy if it becomes even more interesting in a few years’ time.
      Have a Merry Christmas!

  4. Good article. Do you think the fed will be able to keep up with the interest rate increases? The Economist has had a piece or two about how every other developed country that has recently tried to bring rates above 0 has had to bring them back down again.

    • I think this is the 22 trillion $ question of 2016.
      On one side, the US economy is ahead of the world in the recovery. QE has stopped, unemployment is down, it seems natural that the next step is to raise rates back to normal levels.
      On the other side, if the rates increase too fast, dollar denominated bonds will be even more attractive than they currently are compared to the 0% in Japan and Europe. This would strengthen the dollar, hurt exports and lower earnings would drive equities lower.
      The Fed has 3 objectives : maximum employment, stable prices and moderate long term interests.
      So I’d think that as long as inflation gets closer to 2%, the Fed should be able to continue driving the interests rates higher.

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