Over the past few months, Fed officials have been sending mixed signals about future interest rate hikes. On the one hand, most officials acknowledge that the economy is strong and that inflation is rising faster than expected. Although on the other hand, they also point to a recent stock market correction as a sign that markets are overreacting to concerns about trade wars and will soon cool again. But whatever their private misgivings may be, most Fed officials will still follow through with another rate hike in September. After all, it’s what they’ve always said they would do if the economic data remained strong. The subjects of this post are why and how it impacts you as an intelligent investor.
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What is a rate hike?
A rate hike is an increase in the interest rate that the Federal Reserve charges banks on short-term loans. Banks use short-term loans to meet their reserve requirements and make new loans to businesses and consumers. It is more costly to obtain a loan if the rate is higher. For example, if the Fed were to hike the interest rate on short-term loans from 1% to 1.5%, banks would have to pay an extra 0.5% on their short-term loans. Raising banks’ borrowing costs would make it more expensive for businesses and consumers to borrow money, making it more costly to make loans.
The Fed’s basic logic for raising interest rates
The Fed has established an inflation target of 2%, a moderate inflation level that keeps the economy thriving without producing too much chaos or driving prices up too fast. The Fed’s job is to “catch up” to inflation and bring it back down to 2%. The Federal Reserve’s objective of lowering the economy’s temperature and preventing inflation from rising is fulfilled when interest rates are raised. When the economy gets too hot, people are employed at all hours, factories are running 24/7, and wages rise too quickly. The Fed’s job is to slam on the brakes with a rate hike to bring the economy back to a healthy pace.
This month is likely to witness Fed mega-rate hike.
The rise in rates in September is expected to be significant. Since March, the Fed’s inflation-fighting measures have driven rates up aggressively. As a result, another 75 basis point (or even higher) rate hike may occur on September 21, just as we saw at the last two meetings.
How the Fed Rate Hike May Affect Investors
The Fed’s primary goal when it raises interest rates is to prevent inflation from getting out of control. But that doesn’t mean the Fed’s rate hike is always suitable for investors. A rate hike could be bad for investors. Investors benefit when interest rates are low (and they can get a high return on their investment without risking much). Investors lose money when interest rates are high (when it’s harder for them to earn a high return rate without taking on many risks). A Fed rate hike raises the cost of borrowing money, which lowers the demand for stocks and drives down stock prices. That’s because businesses are more likely to use other forms of financing, like bonds, instead of stocks to raise capital. A considerable rate rise from the Fed could cause the stock market to tumble, and those with a lot of money invested there would suffer.
What happens after this?
After this, things get more complicated for the Fed because the economic data will become less predictable. September is probably the one time of the year when the Fed’s data is the most reliable. For the rest of the year, the Fed will have to decide whether to hike rates again based on the same data they used to decide to hike in September. That data may show that the economy is still strong, but it isn’t as straightforward as last time. The Fed will also have to consider the impact of additional rate hikes on the economy. A weaker economy could cool inflation and make a rate hike unnecessary. But a strong economy with higher inflation could need another rate hike.
Bottom line
Investors should maintain diversification and not be overly concerned about short-term market gyrations, irrespective of what the Fed does in September. Instead, investors can benefit from this economy if they maintain a long-term approach.
