Making Sense of The Fed and Rising Rates

You’re likely inundated with headlines or friends talking about the Fed raising rates. This post is going to cover what "the Fed" is, rising rates, why it is important to understand, and some potential implications of rising rates.

What is the Fed?

When you hear someone mention “The Fed”, that's a reference to the Federal Reserve. It's the central bank of the United States and aims to keep the economy operating efficiently. It attempts to do this by focusing on employment and inflation. More specifically, the Federal Open Market Committee (FOMC) is a group made up of members of The Fed that meet and vote on what to do about monetary policy. They set a target rate that they believe will help achieve employment and inflationary goals. This rate, known as the federal funds rate, is used by financial institutions to lend money back and forth to each other.

Rates and Where We Stand in 2022

First things first, some historical perspective is necessary. The average federal funds rate going back almost 70 years is 4.62%. Let’s take a look at the past 5 years:

What was already a lower than average rate in 2018-2019 cratered in 2020 in response to the global pandemic. This move to near 0% was to encourage spending via favorable lending rates for consumers and businesses. Fast forward to 2022, The Fed now believes that the economy is in better shape, albeit with high inflation due to many factors, and has decided to start periodically increasing the fed funds rate. March saw the first increase with 6-7 periodic increases expected over the next several months.

When we look at a chart showing the funds rate over the past year, you can see the increase in March from historic lows. As of April 5th, the fed funds rate sits at .33%, higher than last year but still 14x lower than the historical average.

Why is the Federal Funds Rate Important?

Why should you care about the federal funds rate? In addition to impacting inflation, economic growth, and employment, the fed funds rate sways how lenders offer rates to consumers. This trickles down into many aspects of our financial lives. I won’t get into what this means for stocks and bonds because that is a longer conversation. But let's look at some of the pros and cons rising rates have on your household finances.

Pros

• The fact that The Fed is raising rates typically means they believe the economy is in a better place than they were while rates were lower. Raising rates now is intriguing due to the Covid-related shortages and the conflict in Ukraine. There are many factors to keep an eye on. Is the economy improving? Time will tell.
• The yield that you earn on savings accounts should increase. Emergency funds of cash, CDs or other savings should get a higher return than before, which can help build up your assets.

Cons

• Almost all credit card rates are variable. If the fed raises rates, lenders don't want fewer profits, so your credit card company will increase the interest rate on your debt. Of course, it is best to pay off your credit cards in full each month, but we know that that is not always feasible.
• If you have an adjustable-rate mortgage or HELOC, your rate will increase. Start preparing for these increases and have a plan of action. Even though rates are increasing, they are still pretty low compared to historical averages. It may make sense to look into a fixed-rate loan, instead.
• Increased borrowing costs are coming. If looking for an auto loan or a new mortgage/refinance, you’ll likely pay more for the same home or car than just a few months ago. Set up a budget to handle higher expenses. The trouble I see families get into when it comes to their household finances often comes from over-extending themselves on home/auto expenses, leaving no wiggle room for other priorities.

What Should You Do Next?

I hope this puts some perspective on how you could be impacted by The Fed raising rates. There are certainly implications for your investment portfolio that I didn't cover here. For that, reach out to your financial planner to analyze the impact on your portfolio. For consumer debt, it’s more important than ever to prioritize eliminating it. If you have both fixed-rate and variable-rate loans, prioritize paying down the variable-rate loans to minimize the effect of your interest rate increases. As is always the case, having a sound financial plan that takes many variables into account is the best route. Being prepared for different market environments versus being reactionary helps you mitigate negative impacts and helps you avoid mistakes.

Written by Nick Vail, CFP®