If you’ve been paying attention to the news, you certainly know that inflation is running pretty hot.
To combat this, the Federal Reserve has chosen to hike interest rates – specifically, the federal funds rate.
But how does that work? And what is that rate?
Toni Nasr, our guest poster today, is a fintech analyst at Investing in the Web. He is a Chartered Financial Analyst (CFA) and a Financial Risk Manager (FRM) with a background in the banking field and in investment research.
In this post, he’ll uncover what the federal rate hike really means for Americans, why these numbers continue getting worse, how this can impact your wallet, and finally, what you can do about this to make money.
What is the Federal Rate?
Known as the “Federal Funds Rate FFR”, the federal rate is the rate at which banks and other depository institutions lend money to each other on an overnight basis. It is set by the Federal Reserve and it is tracked by everyone, as it is one of the tools available to the Fed to manage monetary policy.
How Does It Work and Impact Our Wallet?
The Fed rate directly affects your wallet on many levels, such as your deposits, loans, credit cards, and mortgages with variable rates. A higher rate is good for savers but challenging for borrowers. And a lower rate has the opposite impact.
For example, when the Fed lowers the rate range (expansionary monetary policy), the target would be to increase growth and boost economic activity across different sectors. The opposite occurs when the Fed increases rates (contractionary monetary policy). The goal would be to slow the economy and curb inflation.
Why Has the Fed Increased Interest Rates?
As demand increased sharply, prices also rose, fueling inflation. The Fed decided to increase interest rates to control this trend of increasing prices and decreasing demand. As said earlier, higher rates are challenging for borrowers. Consequently, consumers won’t be purchasing anything other than the necessary products. Hence, inflation and an overheated economy are back on track.
How Does the Rate Increase Affect Savers?
Savers take a hit when the Fed lowers its rates as their money at the banks will earn less, and they will likely want to invest elsewhere to get better returns.
On the other hand, a benefit of the Fed rate increase is the higher interest rate you earn on your savings accounts. This is because banks and depository institutions link the rate on deposits directly to the Fed Rate.
What the Federal Rate Hike Means for House Buyers
In contrast, when the Fed rate increases, adjustable-rate mortgages become more expensive. Hence, home buyers won’t be able to afford the loan they want to buy their appropriate house. So, they take out smaller loans to buy smaller houses, which directly impacts the housing industry. Once demand decreases, housing prices also go down.
What This Means for Borrowers
The Fed’s most recent rate hike and the upcoming hikes would result in more expensive credit card bills if you carry a balance (which you should never do).
Usually, to set the credit card percentage rate, credit card providers add some percentage points to the Fed’s rate. This means once the Fed increases rates, your interest on the credit card will increase. If your rate was previously 16.00%, following the 75 basis point increase in June, your new rate would be 16.75%. Similarly, if we take new car loans from Bank of America, the rate increased from 3.29% APR last March to 3.79% in June.
Real Interest Rates vs. Nominal Interest Rates
The nominal interest rate is simply the rate advertised by financial institutions such as banks, where they advertise their products without considering the impact of inflation. The real interest rate is the nominal interest rate but adjusted for inflation. Real interest = Nominal interest – Inflation.
Real interest rates can provide insights into the return received (if you are depositing money) after factoring in inflation. So it might help you gauge the true inflation rate in case it is not disclosed. Nominal rates measure how much you end up paying or receiving interest, but not how the purchasing power of your money has evolved. You should check the real interest rate when making an investment decision.
When inflation is high, it decreases an investor’s purchasing power, and during periods of low inflation, purchasing power increases.
The best way is to explain it with an example. Suppose a product costs $100 at the beginning of the year, and you decide to invest that $100 at 2% for 1 year rather than buy the product. As such, you will end up with $102 in one year. If the price of that product now is $103 (inflation is 3%), you won’t be able to buy it anymore.
So the nominal interest rate was 2%, while the real interest rate was -1%. So, if a real interest rate is positive, it implies you will have more purchasing power in the future if you start saving today. In contrast, if the real interest rate is negative, saving today to buy the same product later won’t be feasible, as your purchasing power will diminish.
Investing During Inflation
In periods of high inflation, your primary concern should be to at least keep your purchasing power. High inflation levels are a new reality not witnessed by most market participants in the last 20 years, where the average inflation has been below 2.5%.
Besides, the typical 60/40 portfolio may not temporarily work as expected since inflation affects both stocks and bonds not only in declining returns but also in the higher correlation between those asset classes, so decreasing the diversification benefits.
The solution could be investing in I Bonds and TIPS, or alternative assets such as gold, real estate (REITs) and commodities through an investment platform. But not doing it blindly! Since market expectations tend to be priced in, you can be late to the party.
One indicator to keep an eye on is the breakeven inflation rate. Using the 10-Year rate as a reference, the market is discounting an inflation rate of 2.7% in the next ten years. So, if you believe that inflation will be higher, investing in TIPS may be a solution in addition to allocating to the alternative investments mentioned.
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