After keeping interest rates low since late 2018, the Federal Reserve hiked them by 0.25 percentage points on March 16, 2022 and then .5 percentage point on May 4th. The Fed has hinted it may raise interest rates by another 1.25 percent or more before the end of the year.

It's not uncommon, but raising rates hasn't happened this much in a long time.

In the high-inflation days of the early 1980s, federal interest rates spiked as high as 19.1%, but the Fed (as the Federal Reserve is often known) has kept interest rates below 5% since 2007. During the COVID pandemic, in fact, the Fed slashed the rate to nearly 0% in an effort to stimulate economic recovery. 

Why does the Federal Reserve lower the interest rate when it wants to stimulate the economy and bump it up again when it needs to cool things off? And how could the recent rate increase impact your investment strategy?

A Short Introduction to Interest Rate Hikes

Though an economically powerful — and politically controversial — agency, the Federal Reserve System remains a mystery to many Americans. It shouldn't.

The Fed is perhaps the most powerful economic agency in the world. So investors need to be aware of what it is, what it can do, and why its actions matter. 

What is the Federal Reserve?

Throughout the 19th century, the United States had no central banking system. Consequently, banks were chartered by their states instead of the federal government. This approach built an inefficient and unstable banking system, which resulted in a series of economic crises.

President Woodrow Wilson signed legislation in 1913 that created the Federal Reserve System. The system is composed of twelve public-private regional banks with the New York Fed being the most prominent since it oversees the largest amount of assets and helps regulate Wall Street.

The Federal Reserve's mandate is to manage monetary policy. Its goals are primarily priced stabilization and full employment. The Fed tries to achieve those goals by selling or buying bonds and influencing interest rates.

After the Great Depression, the Federal Reserve gained considerably more power than it had. Recently, some elected leaders have criticized the Fed as both ineffective and unconstitutional. Nevertheless, they have not succeeded in abolishing the system.

What Does the Fed's Interest Rate Hike Mean?

The Federal Reserve can only change a single interest rate known as the federal fund rate. This rate sets the amount that financial institutions can charge each other for money they borrow overnight. Meaning it becomes more expensive for banks to borrow from each other. Although the federal funds rate is not directly tied to the rates that retail banks offer to borrowers, it acts as a starting point and ends up influencing those rates.

Typically, the Fed raises rates when the economy is running too hot and inflation is a real concern. 

If the U.S. economy were a car, lowering interest rates would be like pushing the gas pedal, and raising them would be like pressing the brake.

As of March 2022, inflation in the U.S. for the last 12 months stood at 8.5 percent, the highest rate since 1982. As a result, gas, food, and housing prices have skyrocketed. To protect American consumers, the Fed is raising interest rates, thus making borrowing more expensive, reducing the amount of loans taken, and ultimately taking money out of the economy as an attempt to lower the inflation rate.

What Happens to Mortgages When Interest Rates Go Up?

The Federal Reserve does not raise mortgage interest rates directly. It does, however, increase banks' costs to borrow the money to create the loan (increasing the federal funds rate). In turn, the bank or other lending institution passes those extra costs along to the borrower.

What that means is that once the Fed hikes its interest rate, mortgage interest rates also go up. In turn, this makes it more expensive to buy real estate. Some potential purchasers may decide to wait for interest rates to go down, or they may no longer be able to afford the larger mortgage balance. 

Consequently, the ratio of houses on the market to home buyers in the market can equalize, stabilizing or driving house prices lower. Historically, this is in fact what has happened. However, there is no guarantee this will happen in today’s market.   

Borrowers who have an adjustable-rate mortgage may find their house payments increase in the very near future. Homeowners who hold a flat-rate mortgage or no mortgage at all will not see a change in their mortgage costs no matter what the Fed does.

How Does an Interest Rate Hike Affect Stocks?

The value of the stock market often rises or falls based on whether or not investors believe the larger economy is expanding or contracting. 

Bullish investors, those who see the economy growing, are often more likely to buy stocks since they want a piece of the economic pie. Bearish investors, those who believe the economy will soon shrink, are more likely to hold or sell investments since they want out before the market tumbles.

When the Fed raises interest rates, economic growth generally slows. As a result, many investors turn more bearish, selling current shares and not buying new ones. The overall effect often is to dampen the stock market's growth or even cause it to lose ground for a while. 

The Relationship Between Inflation and Interest Rates

Interest rates are often linked to Inflation 

Here's how it works: inflation makes the value of money decline over time. For example, it would take $3,489.13 in 2022 to buy what you could purchase for $1,000 in 1980. As a result, Americans are often incentivized to spend or invest their money now. Tucking it away in a savings account, which might not keep up with inflation, only assures your money's purchasing power will decline.

As a broad example, let's say you were looking to borrow $10 million this year, and you expect an inflation rate of 10% next year. For your lender to make money, they would have to charge you an interest rate above 10%. Unless you really need the money now, you'll probably pass on such an expensive loan. Less money in circulation helps cool off the economy and drive prices lower.

In general, the federal government responds to inflation by raising interest rates. That's what happened in early 2022 when the Federal Reserve raised its rates after seeing the brisk pace of inflation in the American economy. 

How is Inflation Measured?

The Consumer Price Index (CPI) measures inflation. The CPI measures the change in the cost of living for 93% of Americans and provides an average. 

Each month, the Bureau of Labor Statistics (BLS) determines the CPI by calculating the cost of 80,000 goods and services Americans typically buy. The BLS weights these goods and services according to their importance. Using this data, the BLS determines the rate of inflation or CPI.

How Do Higher Interest Rates Help Combat Inflation?

An interest rate spike can reward savers and punish borrowers. 

A higher rate returns more money on savings, certificates of deposit, and money market accounts. The idea is that Americans will have an incentive to save more money. Without this cash floating around in the economy, in other words, if consumers are saving instead of spending, this can decrease demand and the supply-demand curve will generally equalize.

Borrowers, though, get hit with higher bills. Credit cards, mortgages, and personal loans all cost more, which also de-incentivizes consumers from spending. 

Can Raising Interest Rates Really Control Inflation?

That depends on which economist you ask! Interest rates are certainly not the only factor that affects the economy. Right now, the war between Russia and Ukraine, global supply chain woes, Chinese factory shutdowns, and the lingering effects of COVID are all impacting inflation. 

Interest rate hikes may or may not be the solution to inflation. As consumers and investors, however, we have no control over the Federal Reserve's decision on the matter. We can only prepare and care for our financial reserves in whatever economic environment that we are given.

Short-term vs. Long-term Investing in an Inflationary Economy

In 20 years, a four percent inflation rate can cut the value of a dollar in half or double the cost of a product. The good news, though, is that long-term the stock market usually outperforms the rate of inflation, sometimes with plenty of room to spare. 

As an investor, the more pressing question is how is the economy? In the past, markets have tended to react more negatively to inflation when the economy is contracting or in a recession, than when it is growing. 

Short-term Bonds versus Long-term Bonds

Bond prices are inversely linked to interest rates.

All bonds are impacted by interest rate. Short-term bonds (bonds that have maturity dates of less than three years) are less sensitive to interest rate changes. Intermediate and Long-term bonds, though, will decline more in value when interest rates jump.

When the Fed raises rates, new bonds have a better rate of return. Investors, therefore, are more likely to buy these newer, more valuable bonds than they are to take old bonds with lower return rates off another investor's hands.

Can Rising Interest Rates be a Good Thing?

Rising interest rates are neither good nor bad. 

A car comes equipped with both a gas pedal and a brake. Sometimes you should use one and sometimes the other. It's not bad to press the brake when you need to. 

If you're a saver or a very conservative investor who prefers bonds, money markets, and certificates of deposit, higher interest rates can be a benefit. You may just have to wait for the higher rates to catch up. On the other hand, if you’re looking to borrow or are holding credit card debt, an adjustable-rate mortgage, or a home equity line of credit, you could take a big hit from higher rates.

How Interest Rates Can Affect Your Financial Future

Well if you’re borrowing money - the higher the interest rate, the more money you pay to borrow that money. So it comes down to your current and future goals. 

Prolonged high inflation can be a threat to any economy or near-term goal. Raising interest rates, however, that helps curb inflation can actually extend the economic growth cycle.

We can’t control the current economic cycle, inflation, or interest rates. We can, however, control how we respond; a carefully thought out and applied strategy can improve your overall financial stability now and in the future.  

At Cooke Wealth Management, we believe in applying biblical principles that can help you be a wise financial steward, applying principles that help you focus on the things you can control; manage spending, avoid the burden of debt, build reserves and liquidity, and think and plan long-term. When it comes to investing a well-diversified portfolio built on sound financial principles may help you weather the coming economic storm. 

Make an appointment with an advisor at Cooke Wealth Management today to discuss how you can keep your financial life secure in inflationary times.