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 | How a Rate Change Affects You and the Economy | ||
| Figuring out the Fed | ||
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| Hooray for Rate Hikes | ||
| What’s Next for Bonds | ||
Federal Reserve officials decided Wednesday to raise two key interest rates by a quarter of a percentage point. This is the first time the Fed has raised rates since May 2000, but indications are it won't be the last.
The Federal Open Market Committee raised its federal funds rate -- the rate banks charge each other on overnight loans -- to 1.25%. The Fed governors raised the discount rate -- interest charged when banks borrow overnight loans directly from the Federal Reserve -- to 2.25%.
"With underlying inflation still expected to be relatively low, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured," the official Fed statement says. "Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability."
The key phase in all that Fed-ese, watchers say, is measured pace -- code for a series of 0.25% hikes for the near future. However, by stating they will react "as needed," the governors open the door to a 0.5% move if inflation heats up.
The last time the Fed began to ratchet up rates was in June 1999. By the time it was finished, the Fed had raised rates six times in 11 months, boosting the federal funds rate a total of 1.75 percentage points, to 6.5%. Currently, the rate is at a 46-year low of 1%. The federal funds rate is typically about two points above the inflation rate, which stands now at about 1.7%. So the federal funds rate has far to go before it reaches a "neutral," or normal, level of 3% to 4%, says Anthony Crescenzi, chief bond-market strategist for securities-trading firm Miller Tabak.
Any increase to the funds rate would likely be followed by a similar boost to commercial banks' prime lending rate, the benchmark for many short-term consumer and business loans.
Our forecast
By year end, we expect the Fed to have increased the benchmark federal funds rate to 2%.
Long-term interest rates will move higher as well. We see the ten-year Treasury note yielding about 5.4% by year end, up from about 4.8% now, while the average 30-year fixed-rate mortgage will climb to about 6.7% from the current 6.3%. The 30-year rate is likely to hit 7.2% by the end of 2005.
Starting next year, the Fed will hike rates fairly regularly, on the order of once every other month. The aim will be to return monetary policy to a neutral stance -- a level that neither stimulates nor checks the economy -- and keep inflation bottled up. The fed funds rate will probably top out at about 4.5% by mid-2006.
- Peter Goldstein,
KiplingerForecasts.com
How to invest
Long-term bonds make no sense, even if interest rates rise fairly slowly. You should stick to short- and intermediate-term funds, such as Vanguard Limited Term Tax Exempt (VMLTX) and Vanguard Intermediate Term Tax Exempt (VWITX). Fidelity Floating Rate High Income (FFRHX) is designed to rise with interest rates.
In stocks, you'll want to avoid companies that depend heavily on debt markets to stay afloat -- at least to the extent that looming problems aren't already factored into their stock prices. Automakers, homebuilders, and utilities will do poorly -- although over the long-term, homebuilders will be okay.
The stock market overall has been depressed by fears of terrorism and rising oil prices. But surging corporate earnings, riding on the headwind of rising rates, should overcome those bugaboos.
What's more, many stocks, including some financials, will do just fine as rates turn up. In sum, this is no time to abandon stocks.
- Steve Goldberg,
Kiplinger's Personal Finance
What's ahead for savers and borrowers
If you have an adjustable-rate mortgage, you could face a quick hit. If you have a one-year ARM, the rate increase will flow through at the next adjustment. The amount of pain depends on the size of your loan. Say you took out a $300,000, one-year ARM last summer with an interest rate of 4.1%. If rates go up by a quarter-point, your monthly payment will increase by about $43 (a half-point hike would add $86).
Borrowers with ARMs tagged to the London Interbank Offered Rate (Libor) index are probably already paying more. Anticipating the Fed's decision, this index increased from 1.34 in March to 1.81 in April. "That's a one-half percentage point increase before the Fed has done anything," says Keith Gumbinger, of HSH Associates, a financial surveyor and publishing group.
If you're shopping for a mortgage this summer, consider a hybrid ARM, which offers a lower initial interest rate than a 30-year fixed-rate loan and insulates you from future rate hikes for one, five, seven or ten years. Borrowers with one-year ARMs could face annual increases if the Fed's action this summer is the beginning of a long series of rate hikes. With a five-year hybrid, however, you'd be protected for the first five years, after which annual adjustments would be possible. With hybrid ARMs, the initial rate rises with the length of the lock-in period. When the average rate on one-year ARMs was recently 4.08%, for example, the average rate on five-year hybrids was 5.44%, and the rate on ten-year hybrids was 6.09%. Choose the period that reflects how long you expect to be in the home.
Whether you choose a fixed or adjustable-rate loan, be sure to lock in your rate. The standard lock-in typically costs you nothing and guarantees your rate will hold steady for 45 days. If a lock-in lets you dodge a quarter-point rate hike on a $300,000 mortgage, it will save you several hundred dollars in the first year.
If you have a home-equity line of credit, your minimum monthly payment will rise within one or two billing cycles. The prime rate -- to which most equity lines are tied -- moves in lock step with the federal funds rate. If you're currently paying interest only on a $30,000 balance, for example, you'll pay $7 extra each month. If you are paying a minimum monthly payment (typically 1% or 2% of the balance), the required payment won't change, but more of each check you write will go to pay interest instead of principal.
If you carry a balance on your credit cards, you probably have nothing to worry about, even though about 65% of all cards have a variable interest rate. Those rates are often based on the prime, but have a minimum rate, or floor. At 4%, the prime is so low that even a half-point increase wouldn't push the card rate above the floor. If you have a fixed-rate card, the issuer probably won't increase the rate in this very competitive environment.
If you are in the market for a new car, don't feel pressured to lock in a loan or lease. According to Melinda Wilson, a spokeswoman for Ford Motor Credit, auto-financing rates are unlikely to react to this Fed rate hike. Carmakers are still using special incentives -- such as rebates and cut-rate financing -- to move the metal, and the competition is too intense for them to pass along a rate hike.
If you have cash stashed in a money-market mutual fund, your rate will rise from the pathetically low 0.51% average, but it will take a couple of months. After a quarter-point hike, the average rate would be just 0.76%, which translates into $7.60 in your pocket on a $1,000 balance. That might buy you a beer at a baseball game.
If you save with certificates of deposit, you'll see an increase of a quarter-point to a half-point next time you reinvest. CD rates depend on the bank's need for funds, its competition and current interest rates. Peter Crane, managing editor of Money Fund Report, expects to see a boost in CD rates about three to four months after the Fed acts. Whenever you buy, it pays to shop: The top-yielding six-month CD from Corus Bank in Chicago yields 2.06%, well above the 1.34% average. If you purchase a CD, stick to a short-term certificate so you will have cash available if rates continue to climb.
If you're in the market for savings bonds, Dan Pederson, author of Savings Bonds: When to Hold, When to Fold and Everything In-Between, recommends buying series EE bonds now. Rates rose in May along with the yield on five-year Treasury notes, and you will benefit from future rate increases (the rate is reset every six months). The bonds pay 2.84% through October 31, and Pederson expects the rate to bump up to between 3% and 4% on November 1. Because EE bonds have historically yielded two percentage points over inflation, they're a better deal than inflation-indexed series I bonds, which are paying a fixed rate of one percentage point over inflation.
- Joan Goldwasser,
Kiplinger's Personal Finance
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