Interest rates: What you need to know
Russell Price, Senior Economist, Ameriprise Financial
The Federal Reserve appears headed for multiple interest rate hikes this year
Investors often exercise caution during periods of rising interest rates
The Fed's actions reflect a strong economy
The Federal Reserve is widely expected to raise its ultra-short (overnight) interest rate target two more times in 2017, by +0.25% each time. If this projection holds true, it would leave the Fed's overnight lending rate at a mid-point of 1.375% by year-end, versus its 2016 year-end rate of 0.625%. Think of this as the interest rate banks charge when lending funds to other banks; but, more importantly, it greatly influences the broader interest rate environment.
If you are an income-oriented investor, the prospect of higher interest rates may be music to your ears. The benefits to savers, however, often lag the Fed's interest rate hikes. Banks need to make sure they can pass along higher rates to prospective borrowers before they can offer higher yields on savings and other interest-bearing accounts.
Higher rates could rattle equity markets
Of course, higher borrowing costs can be a headwind for economic growth, and it's not uncommon for financial markets to see heightened volatility as the Fed raises rates. The very cautious attitude Fed officials have taken toward interest rates in the current recovery, however, should temper fears of rates rising too soon or too fast, in our view.
We also note that many consumer and corporate borrowing costs have already moved higher, partially in anticipation of Federal Reserve action. The yield on the benchmark 10-year Treasury note, which is the basis for many consumer borrowing costs – particularly mortgages, ended the month of March at 2.40%, as compared to 1.78% a year earlier.
A signal of economic strength
Investors may worry about the impact of higher interest rates on the economy and corporate profits, but higher rates themselves are a consequence of strong economic conditions. Recently, inflation measures have been rising as demand improves and the labor market continues to tighten.
With a dual mandate from Congress, the responsibilities of the Federal Reserve require it to seek full employment in the labor market within the context of stable prices. Maintaining a balance between these objectives is certainly difficult, but if a balance is achieved, it could enable a sound and prolonged period of economic expansion.
Over the last few months stock prices have registered solid gains based on signs of:
Improved economic momentum
Stronger corporate profit trends
Optimistic predictions for lower taxes and higher infrastructure spending tied to the federal government
At the time of this writing, the outlook for fiscal policy remains uncertain, but we believe economic improvements are sustainable – even if interest rates edge higher.
The time is right
We believe the time is right for the Federal Reserve to continue raising interest rates at a moderate pace. The labor market is finally close to full health, and there have been signs that inflation is beginning to percolate.
We note that interest rates are still exceptionally low by historical standards, and rate hikes are likely to come at a slow and economically manageable pace in the quarters ahead.
Nevertheless, turning points in Federal Reserve interest rate policy should be a fundamental consideration for long-term investment portfolios. Although we are optimistic regarding the economy's ability to tolerate higher rates, this policy change has many implications.
We recommend discussing these potential changes with your financial advisor to make sure your portfolio is properly positioned for an environment with modestly higher interest rates.