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Higher Interest Rates—What Do They Mean?

44891412_sFor the first time in nearly a decade, the Federal Reserve will be raising the key interest rate. The “key rate” is the specific rate that determines bank lending rates and the cost of credit to borrowers. The key rate is one of the chief tools used by the Federal Reserve (Fed) to implement its monetary policy. Basically, when the Fed wants to expand the money supply, typically it lowers the rate. When the Fed is in a contraction phase, it will raise the rate to increase the cost of borrowing. Janet Yellen, the Federal Reserve chairman, says to look at the latest rate increase as “a testament . . . to how far our economy has come in recovering from the effects of the financial crisis and the Great Recession.”
 
At the end of 2008, the Fed took interest rates down to zero in an attempt to boost the struggling economy out of the Great Recession, but those in Washington now believe the US economy is strong enough to support itself.
 
Hmmm.
 
No matter if you were naughty or nice this year, the rate hike is likely to affect millions of Americans. Anyone with a credit card, anyone looking to buy a home or a car, and anyone with an investment account, like a 401(k) or an IRA, will feel the weight of this announcement. However, even though the decision to raise the rate has been made, things will not change overnight. Interest rates will begin rising slowly, which gives everyone a chance to adjust and prepare for the changes.
 
So let’s take a look at how this rate hike and future rate hikes might affect you. Currently, the Fed plans to increase the rate by no more than 0.25 percent at first. It is expected to go up 0.25 to 0.50 percent over an unspecified amount of time. In the grand scheme of things, if this is the most interest rates rise, then they will stay incredibly low. Before that subtle increase, the interest rate on a 30-year mortgage has been just under 4 percent. This is still 2 to 3 percent lower than previous decades’ averages. So even with the slight increase, if you are looking to buy that new home or car, the interest rate hike will probably not affect your decision. In fact, this is a good time to start thinking about those big purchases, as this could be a sign of higher and higher rates in years to come.
 
Those of us who invest in the markets need to be prepared for a volatile market. Heck, we have already been on a roller coaster ride since May. Recent months have given investors plenty to think about, with oil prices dropping, China’s economy struggling, and the global economy uncertain. Furthermore, most other central banks, such as the European Central Bank, have been moving counter to the Fed, cutting their interest rates deeper into negative territory. They are effectively charging commercial banks more for holding their reserves. The hike here in the United States will likely trigger volatility in our stock and bond markets, since, essentially, the two most powerful central banks are colliding on their views of inflation and deflation. So, make sure you review your appetite for risk exposure.
 
As the two most powerful central banks collide on monetary policy, this will also likely strengthen the US dollar. For those of you planning to travel abroad, that is good news, since the dollar will buy more. However, a strengthening dollar will probably hurt US companies that do business abroad, since it will be more difficult to sell products in foreign countries. Additionally, any markets that have loans in US dollars may have trouble paying those loans back. This stress could lead to defaults, which will only cause more problems for what has already been a tough year for the global economy. Some believe that the Fed’s rate hike will set off a chain reaction that will negatively impact other countries’ already struggling economies—thereby making US trade more difficult and bouncing back to hurt the US economy. Heck, the MSCI Emerging Market Index is already down 20 percent this year.
 
Lastly, this rate increase may affect people who like to use their local bank as part of their investment strategy. Folks, for years the Fed has penalized savers. Gone are the good ol’ days of simply putting your money in a CD earning 6 percent. And, unfortunately, those days are not coming back any time soon. However, with rising interest rates, those looking to save may get a little boost. Even though the Fed’s announcement won’t spur the banks to immediately start offering higher interest rates, it is a sign of a change in the winds. It’s expected that over the next two years, people funneling money into those savings accounts will likely see a small increase in the earnings on them. Frankly, even with a slight bump in interest rates, I don’t see savings accounts keeping ahead of inflation.
 
Overall, the Fed’s announcement should force us to do one thing: be vigilant and stay alert. Folks, things will be changing, and with any change, there are pitfalls to avoid and opportunities to seize.