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Practical Economics

Learn What the Fed's Eventual Rate Increase Means to You

Slightly higher loan payments and short-term market volatility are in the cards.

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When it happens later this year—late October or December—the Federal Reserve’s first interest rate hike in over nine years won’t give the economy a sharp kick. It’ll be more of a gentle nudge, though significant.

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The quarter-point rise in the federal funds rate from nearly zero will be the first in a series of small hikes aimed at normalizing monetary policy. The goal is to gradually move the benchmark borrowing rate to about 3% or 4% a year so it can be used as a tool to manage the economy’s health—rising if inflation threatens, lowering if spending needs a boost to support growth.

We expect a second increase next April or June, and a third later in 2016.

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For practical purposes, here’s what those actions will mean:

--The average five-year car loan, for $25,000, will carry a 4.85% interest rate by the end of 2016, adding $18 a month to the payment.

--The interest rate on a typical 30-year mortgage will jump to 4.6%, from 3.9% now.

--The prime rate, which banks charge their best business borrowers, will also grow, to 4% from 3.25% now.

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In time, banks will also offer depositors a higher return on their money. But that won’t show up initially because banks will use the first increase to improve their margins.

For investors, the speed of the increases matters most. If this year’s hike is followed by another in March, that could signal that the Fed will raise rates about three times a year over the next few years. We think a more leisurely two increases a year is more likely unless economic growth or inflation picks up significantly.

That’s based on Fed Chair Janet Yellen’s comments in June, and again in September: “Let me emphasize that the importance of the initial increase should not be overstated: The stance of monetary policy will likely remain highly accommodative for quite some time after the initial increase in the federal funds rate.”

Yellen has constantly emphasized having to see labor market improvement before raising rates. Now that improvement is here, she will want to carefully evaluate the impact of each rate hike before doing another one, lest the Fed raise too quickly and hinder the improving momentum of the economy.

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Another reason for keeping rates low: Fears of a global slowdown centered on China threaten to push up the value of the U.S. dollar. It’s already up 17% over the past year, depressing U.S. exports and increasing U.S. imports. The Fed wants to avoid making the dollar even more attractive with higher interest rates on Treasury notes.

The rate increases won’t bring an end to the long-running bull market, though it may seem that way because stocks are particularly skittish in the months before and after initial hikes, says BMO Capital Markets chief strategist Brian Belski. He notes seven such tightening cycles since 1982. In each case, the Standard & Poor’s 500 stock index has pulled back significantly in the months around the first hike, including the 34% drop during the 1987 bear market, in advance of a Fed rate-hiking cycle that began in March 1988 and a 14% drop begun in October 1983, a little more than six months after the Fed began another cycle of rate increases.

One year after the initial hikes, stocks were up every time, “suggesting that these periods of weakness were only bumps in the road,” says Belski. The average gain one year out is 6%, below the average annual gain for the S&P, but nonetheless positive. And from the first rate hike through the last in each tightening cycle, stocks rose an average 21% as investors focused on the economic growth that both precipitated and accompanied rising interest rates.

Glenn Somerville and Anne Kates Smith contributed to this report.

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