The Federal Open Market Committee ("the Fed") recently increased its target range for the federal funds rate to 1/4 to 1/2 percent.
What does this mean and what should we expect?
It's been seven years since the Fed aggressively dropped its target range to 0 to 1/4 percent to stimulate economic recovery amidst the financial crisis that began in late 2008. The target range was well below what's known as the "equilibrium rate" of 1.75%. The slow pace of economic recovery since then has delayed rate hikes because the Fed was concerned, up until now, that increases might hurt recovering labor and housing markets.
Why raise rates now?
The economy is now strong enough to begin raising rates toward the equilibrium level. In its statement, the Fed said economic activity is expanding at a moderate pace. Specifically, the Fed mentioned the following:
* Ongoing job gains
* Declining unemployment
* Increased household spending
* Increased business fixed investment
* Improved housing sector
* Low inflation
How did the financial markets respond?
Because this rate hike was so widely anticipated, the markets responded favorably. In the bond market, the 10-year Treasury yield initially spiked at the announcement, but returned to about the same level by the market's close. The S&P 500 rose 1.0% after the Fed announcement the same day. (See chart.)
Interest rates on fixed and variable rate loans have been moving up and down within a narrow range. All of these market reactions are indication that this rate move was widely anticipated and already factored into the financial markets.
What to expect from the Fed going forward?
The Fed's mandate by Congress is to implement monetary policy to achieve maximum employment and price stability, all while maintaining moderate long-term interest rates. Last week's move clearly indicates that they expect that gradual rate increases will foster these goals, rather than inhibit them.
Specifically, the Fed projects four 0.25% rate increases in 2016, meaning it expects rates will be 1% higher by the end of 2016. However, any sign of slowdown could cause the Fed to delay further hikes.
Rates are still "accommodative," meaning they are low enough to stimulate economic growth. The Fed expects continued economic growth and labor market improvements.
Does the fact that this is the fifth longest economic recovery mean we are nearing the end of economic expansion? Not necessarily. It's been said that "economic recoveries don't die of old age" and "economic recoveries don't have a built-in expiration date." It would take specific economic factors to cause the economy to turn downward: Fed policies, economic shocks, asset bubbles, etc.
Should I refinance my mortgage now?
Now is the time to review your mortgage to see if it makes sense to refinance. It's almost certain that mortgage rates will be higher in 2016. From 2003-2007, right before the financial crisis, 30-year mortgages averaged 6.06%, much higher than today's rates. If you have a variable-rate loan, you should expect your interest rate to go up
Review the terms of your loan to see how quickly your rate will rise. Rates on home equity lines of credit (HELOCs) are typically adjusted monthly. As always, the goal of refinancing should be to pay off your mortgage sooner, lower your monthly payment, or both. Avoid refinancing to cash out to pay for vacations, boats or cars.
How does this affect my portfolio investments?
For investors living off the income from their bond portfolio, higher interest rates in the future will be a welcome change, but bond portfolios could take a hit in the meantime. That's because bond prices typically drop when interest rates increase. Review your bond portfolio to shorten its duration and to make sure you have the right type of bonds. Long-term bonds react the strongest to rate increases. High-yield bonds have been selling off in 2015 and have been hit hard.
The stock market reacts quickly to expectations about the future economy and financial markets so this new Fed policy will get the attention of stock investors. Review your stock portfolio to make sure it reflects the current outlook, as well as your personal need for growth and income.