This past week the Federal Reserve (Fed) increased short term-interest rate a quarter of a percentage point. While a quarter of a point is not much, the significance is that rates had been at zero for seven years.
The Fed has a dual mandate, which is to promote stable prices and full employment. What the Fed defines as stable prices is inflation of approximately 2% per year. For the most part inflation has averaged around 2% per year in recent years. Of course some prices have been going up more than 2% per year, such as college tuition, health care, and rents, but other items have fallen in price, such as electronics and recently gasoline.
Employment is where there has been a major change in recent years. During the past recession unemployment on a national basis peaked around 10%, and currently it is at 5%. The 5% level is normally considered to be full employment, as businesses and workers periodically change plans, which causes some unemployment to occur.
There are a few things that are different about this current period of 5% unemployment versus other time frames when unemployment was at this level. The labor force participation rate is at a low level, which implies that many people have dropped out of the labor force. Also, the number of long term unemployed people is higher than there were in prior periods. Finally, wage growth has been quite minimal, though it is showing some signs of picking up a little.
Because the labor market is not as strong as a 5% unemployment rate would imply means that the Fed will be cautious in terms of raising rates further. Essentially the Fed is saying that the economy has improved enough where rates no longer need to be kept at zero, but most likely the pace of future rate increases will be fairly slow.
Essentially what rising rates mean for a consumer is that, if you are a saver it is good news, but bad news if you are a borrower. For borrowers there are two types of loans, fixed rate or variable. Variable rate loans are typically home equity loans, business loans, margin loans on stocks, and credit card loans to some extent. Rates on these loans will move higher with the change that the Fed instituted.
Existing auto loans will generally remain the same, assuming that the contract stipulated a fixed rate of interest. New auto loans being made will likely increase a little, especially for shorter term loans, which currently are very low.
For mortgages the only change will be for those who have variable rate loans, where they will likely see a quarter point increase in their interest rate. For those with fixed rate mortgages there will be no change. For those obtaining a new fixed rate mortgage this move by the Fed will have little impact, as fixed rate mortgages tend to move with changes in the 10 year Treasury rate. This rate may rise in the future, but for now has not changed significantly.
For savers this quarter point move by the Fed probably will not mean much. Most banks did not raise the interest rate they pay on savings accounts, but may do so after a period of time, or possibly wait for the next Fed increase. Money market mutual funds will raise their rates quicker than banks. However, unless someone has a substantial amount in a savings account, it may not be worth the trouble to switch accounts to get a quarter point higher interest rate.
The big question going forward is how much will the Fed raise interest rates in the coming years. Based on history rate increases over time can be quite significant. However, each business cycle is different, and most likely rate increases will be more muted compared to prior periods.
Current expectations in the financial markets are for rates to rise to a little over 1% in a year, and then go to the 2% range in 2017. Whether rates are at 0, 1%, or even 2%, these are still very low levels based on history. Most likely any future Fed increase in rates will be done in small quarter point increments on a gradual basis.
This move by the Fed can be regarded as a good thing, because it signifies that the economy has recovered enough for rates no longer to be kept at zero. This quarter point move will not change things much for savers or borrowers, but if rate increases continue, there will certainly be some impact over time.
Because this move by the Fed was widely anticipated its impact on financial markets was not too significant. Recent volatility in the stock market is due more to international events, and movements in oil prices versus the change in interest rates. Over time changes in interest rates can impact stock prices, but with rates still likely to remain quite low the effect should not be very significant.
