After months of Federal Reserve Chief Jerome Powell declaring there would be no change in interest rates, the time has finally come for rates to rise. On March 16, the Fed raised interest rates for the first time since 2018. The move was made in an effort to combat inflation, which reached its highest level in 40 years in early 2022.
Interest rates have a close relationship with inflation. But why is that? And perhaps more importantly, how does it affect your financial plan?
The Relationship Between Inflation & Interest Rates
Central banks (like the Federal Reserve) raise and lower interest rates as necessary to either stimulate a nation’s economy or curb rampant inflation. As inflation rises, banks raise interest rates because inflation means every dollar a bank lends out is worth more than the dollar they get back in repayment. Higher interest rates enable banks to make up for that lending “loss” due to inflation.
Additionally, banks raise rates to try to slow down spending and discourage borrowing and buying. Less borrowing and buying typically results in less growth, which in turn results in lower inflation. This cycle of raising and lowering rates goes on and on to keep economies moderate.
Over the last several years before COVID-19, core PCE inflation, which is the Federal Reserve’s favorite measure of inflation, has remained relatively low—hovering around or under 2%. This kept interest rates low, too. However, as money was recently flooding the economy (due, in part, to stimulus from the COVID-19 pandemic), the price of goods started to rise, and inflation was hitting a fever pitch. All along, Fed Chief Powell insisted this was only “transitory inflation,” but we recently hit a point where something needed to be done to keep this inflation from continuing to run wild. Thus, the Fed raised interest rates—and most experts believe more are on their way.
How Higher Fed Rates Affect Your Financial Plan
Higher rates don’t quite have the same impact on your financial plan as inflation, but it’s still something to watch out for. When it comes to your investment portfolio, higher rates mean a couple different things. For starters, if the Fed raises rates, that means the economy is doing well, which is good for stocks. In a growing economy, stocks are likely to do well as volatility subsides. Although, some stocks that are interest rate-sensitive can be hurt by rate increases, while other sectors that are less sensitive can perform better.
Where your portfolio may be affected is in your bond allocation as rates increase. However, fixed income securities pay out a fixed rate of return over a set period of time. So, when you buy a bond at and hold it to maturity, the only way you can lose money on it is if the bond’s issuer goes into default or bankruptcy. However, where you could run into some trouble is if you try to sell your bonds before they mature.
Bond prices fluctuate based on prevailing interest rates. If interest rates go up, bond prices go down. And if interest rates go down, bond prices go up.
Think about it like this: If you own a bond paying 3%, and then a bunch of new, similar bonds come on the market paying 5%, no one will want to buy your bond unless you discounted it to compensate for the below-market interest. Conversely, if you owned a 5% bond and then new similar ones paid only 3%, you could sell your bond at a premium.
What You Can Do
If the Fed raises rates due to growth, that’s usually a good sign for the stocks in your portfolio. But if you’re facing a period of sustained higher interest rates due to inflation, then it might be a good time to increase your allocation of bonds versus stocks. That’s because bonds will be paying relatively higher yields than they have been recently. As clients collect these higher coupons, they will also be rebalancing their portfolios with less risk and volatility than stocks. While stocks are important, having the additional exposure to bonds as yields go higher can provide a better balance of risk in your portfolio.
However, it’s worth mentioning that every financial situation is unique. You should speak with your advisor directly to come up with the best course of action when interest rates go up.
