When the Federal Reserve the (Fed) raised interest rates at the start of last year, there was an expectation that there would be a series of rate increases. However, so far this year, there has not been any further increase in rates.
The principal reason that the Fed has held off on further rate increases has been the relatively weak economic data during the first quarter of the year. In addition interest rates internationally have remained at very low and sometimes negative levels.
Recently, economic data has started to improve and that has increased the possibility that the Fed may start to raise rates again. This past week, minutes from the Fed’s last meeting in April increased the possibility of an interest rate hike at the next meeting in June.
This is not to imply that the Fed will necessarily raise rates at that time. However, prior to the release of the Fed minutes the probability of a Fed rate bump in June had been very low.
When the Fed first raised rates at the end of last year expectations were the rates would be increased by about a percentage point during 2016. Earlier this year those expectation were changed to having just two rate increases, which would total .5%. Until just recently some economists were even predicting that the Fed might go the entire year without a rate increase.
Looking at the current environment, two interest rate increases this year would appear to be a reasonable estimate. Even if the Fed does not raise rates in June, there would be a decent likelihood that they could at the next meeting in July, and then another hike later in the year. Any rate increase would likely be a quarter of a percentage point at a time.
The Fed is always cautious with its statements with regards to what it plans to do. This is because unexpected changes can occur in the economy, and sometimes statements made one month will need to be revised significantly in subsequent months.
Because interest rates have been so low for so long, there is some expectation of this being the norm. Investors and borrowers should in no way expect that interest rates will permanently stay near 0. This is not to imply that interest rates on savings accounts are going back to 5% any time soon, but individuals should be prepared for higher rates.
It is important to note that when the Fed makes changes it impacts short-term rates directly, but not necessarily longer-term rates. Changes the Fed makes will directly impact the interest rate on home equity loans, but rates on first mortgages will not change at the same rate.
Nonetheless, if the Fed is raising short-term interest rates, there will be some corresponding impact on longer-term rates.
For example, if the Fed raises short-term rates one percentage point over the next 12 months, mortgage rates might move half that amount. However, during previous cycles, when the Fed has raised interest rates the impact on longer-term rates has varied.
The impact on the stock market when the Fed is raising rates is somewhat mixed. In financial theory the value of a stream of future earnings for a company becomes less valuable as interest rates rise. That implies that a rise in interest rates is negative for the stock market.
However, because interest rates are currently so low, a modest increase in rates will probably not have too much of an impact on stock market valuation. In addition a rise in interest rates can be thought of as a sign of confidence in the economy, which would be beneficial for stocks, as risk levels are becoming lower.
For now, I do not believe that a gradual increase in interest rates will have too much of an impact on the stock market. Moves by the Fed will be gradual, so any disruption to financial markets should not be too significant. We would probably have to see an increase in rates of at least 2 percentage points from current levels to have a major impact on stock prices.
Consumers and investors should be prepared for an increase in interest rates. The timing and the magnitude of the increases is still uncertain, though it is quite likely that there will be some changes this year.