It was way back March 2020, that the Fed slashed interest rates to zero and launched a massive $700 billion quantitative easing program. The move was a response to concerns over the economy in light of the Covid virus and the measures implemented to tackle the issue.
Skip forward a couple of years and on the 27th of July the Federal Reserve enacted its second consecutive 0.75 percentage point interest rate increase, taking its benchmark rate to a range of 2.25%-2.5%. Many people are wondering what these sudden developments mean and what the future is likely to hold and will interest and savings rates rise?
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- Who sets the level of interest rates?
- What is the Federal Open Market Committee?
- Why did US interest rates fall in 2020?
- What was the benefit of lowering US interest rates?
- Why was there talk of negative interest rates?
- Why is inflation rising?
- Why can inflation be a problem?
- Why would an interest rate rise reduce inflation?
- Are interest rates going to continue rising in 2023?
- What do interest rate rises mean for savers?
- How would an interest rates rise impact mortgage rates?
- Should I fix my mortgage rate?
- How would an interest rate rise affect investments?
- Working with an advisor
Who sets the level of interest rates?
The Federal Reserve, aka the Fed, sets the interest rates for the US. These are the amount of interest that other financial institutions have to pay when they borrow from the central bank. The immediate impact of interest rate changes has a direct impact on what banks charge each other for short-term loans, but the trickle-down impact of these rates feeds into a multitude of consumer products such as adjustable mortgages, auto loans and credit cards.
For example, if the Fed reduced their base rate, other banks which borrow from them could cut interest rates in turn.
Since changes to the base rate can have a significant impact on the US economy, any changes to the base rate are decided by a group called the Federal Open Market Committee.
What is the Federal Open Market Committee?
The Federal Open Market Committee is made up of twelve individuals. The Committee consists of the seven members of the Federal Reserve Board, the president of the New York Fed, and four of the other eleven regional Federal Reserve Bank presidents, who serve one-year terms. The Chair of the Federal Reserve has been invariably appointed by the committee as its chair since 1935, which has helped fuse the perception of the two roles being synonymous.
This committee makes key decisions about US interest rates, such as whether they should rise or fall, depending on the needs of the US economy. Major decisions made by the committee include the policy of Quantitative Easing, launched in 2008 as the subprime mortgage crisis caused global panic on the markets.
Why did US interest rates fall in 2020?
2020 was a difficult year for the global economy and the US, with the Covid virus partly to blame for an alarming fall in GDP as the country entered a brief but alarming recession. Attempts to fight the spread of the virus were primarily to blame as lockdown measures implemented by the government, forced many businesses to remain closed for a significant portion of the past year. Another consequence of lockdown measures was on the global logistics chain, one that is arguably still being felt to this day.
In response to the initial financial shock of the pandemic, the Chair of the Federal Reserve Jay Powell, announced it is dropping its benchmark interest rate to zero and launching a new round of quantitative easing. The Fed said that it “is prepared to use its full range of tools to support the flow of credit to households and businesses and thereby promote its maximum employment and price stability goals.”
What was the benefit of lowering US interest rates?
The ability to set the base rate can be a powerful tool for influencing the economy. This is because interest rates affect consumers and businesses in main two ways:
When interest rates are high, people typically save more as their wealth can generate strong returns. Conversely, when rates are low, interest on savings may have their value eroded by inflation, which encourages people to spend.
When rates are high, loans are more expensive. By lowering rates, people and businesses can take out loans more cheaply, which can encourage spending and investment.
Essentially, the move was designed to support businesses in 2020 by encouraging consumer spending and making it cheaper for companies and banks to take out loans.
Why was there talk of negative interest rates?
The US economy was hit hard by the coronavirus and as such the Fed moved to cut interest rates, to help encourage spending. However, these measures resulted in the “real” interest rates, the rate adjusted for inflation, being negative. And as a direct consequence of which the value of assets rocketed with real-estate, crypto, and even NFT’s.
Despite the efforts of the US government and Fed to mitigate the impact of the virus, the US economy has not yet fully recovered. A mini-recovery in 2021 saw the US economy grow at its fastest rate since 1984, but the strong growth of the final quarter of 2021 of 6.9% came to a juddering halt as the US kicked off the first quarter 2022 with a fall of 1.5%.
The figures for the second quarter 2022 continued this recessionary trend with a contraction of 0.9%. Traditionally two quarters of negative growth would indicate a recession, however the high employment rate in the have given hope that this may prove to not be the case.
In any case on the 25th of July the Fed raised the federal funds rate (the rate at which commercial banks borrow and lend reserves) by 75 basis points, for a second time in a row, to a target range of 2.25% to 2.5%. With the move designed to cool the economy and bring down inflation
Why is inflation rising?
In recent months, the rate of inflation in the US has jumped considerably and this is partly due to the reopening of the economy. The various measures put in place to help combat the coronavirus, including the financial ones, have been removed and as such markets are having to adjust after almost 2 years of global economic slowdown and uncertainty.
As more people get out and spend their money, combined with the supply shortages caused by the current developments in the Ukraine and the pandemic, and concerns over global food supplies prices have started to rise. While some inflation is a good thing (the Fed has an annual target of 2%), too much might negatively impact the US economy.
One of the policies that the Federal Reserve has been using to keep inflation low is “quantitative easing” (QE). In essence the Fed uses its cash reserves to buy securities
Despite the best efforts of the Fed and its QE program, the latest figures reveal that in the month of May 2022, US inflation hit a high of 8.6 percent. Needless to say, such high rates can pose a serious problem for the country’s economic recovery.
Why can inflation be a problem?
Put simply, inflation decreases the buying power of money. The consequences of high inflation can be devastating if wages are not rising as fast as the cost of living, you’re worse off in real terms. It is also not good for business confidence. Firms are unable to make accurate cost and price forecasts and many suppliers sign short-term agreements with businesses as no one can predict future price spikes.
A further problem arises when too much spending causes even more inflation, resulting in a feedback loop.
This can cause inflation to spiral out of control if it isn’t carefully managed. One of the key ways that the Fed deals with inflation is by raising interest rates.
Why would an interest rate rise reduce inflation?
As we mentioned earlier, there are two main ways in which US interest rates affect consumers: saving and borrowing.
When interest rates rise, people tend to spend less and save more. On top of this, it also becomes more expensive to borrow money.
With less money being spent, the demand for goods drops and their price doesn’t rise as quickly.
Are interest rates going to continue rising in 2023?
The Fed has already increased interest rates this year and the forecast, according to St. Louis Fed President James Bullard, is that it will continue to do so this year. According to Bullard the expectation is that rates will continue to increase this year.
In a recent interview with CNBC he said; “I think we’ll probably have to be higher for longer in order to get the evidence that we need to see that inflation is actually turning around on all dimensions and in a convincing way coming lower, not just a tick lower here and there.”
Its not just the Fed that is being bullish on continued rate hikes with the likes of JPMorgan, LH Meyer stating that they believe there will be another 75 basis-point move in September. Whilst Citigroup has gone so far as to say that it believes there’s a risk of a full percentage-point hike in the third quarter.
What do interest rate rises mean for savers?
One of the main groups that would benefit from an interest rate rise would be savers and their interest savings rates in 2023. Especially if interest rates on some savings accounts do end up as high as 2% by the end of year, according to predictions made by some experts.
If interest rates were to increase in 2023, and banks and building societies passed on these increased rates, savings held in cash would benefit from higher growth. This can reduce the risk of your wealth’s true value being eroded by inflation, though this comes with the caveat that it depends on what the rate of inflation is at.
How would an interest rates rise impact mortgage rates?
An interest rate rise may be bad news for mortgage holders because it might lead to higher monthly repayments, meaning you have less money to spend on other things.
For example, let’s say you had £$200,000 left to pay on a tracker-rate repayment mortgage with 20 years left and you were paying 2% interest. According to the Bank of America mortgage rate calculator, your monthly repayment would cost you $1,012.
However, if your interest rate rose by just 1%, your monthly repayment would then cost you $1,109. This would be an increase of just under $100 per month (or around 9%).
Should I fix my mortgage rate?
The prospects of rising interest rates would only be a problem if you have an adjustable-rate mortgage. If you had a fixed-rate mortgage instead, a rate increase would not affect you until the end of your fixed rate.
This might leave you asking the question “Should I fix my mortgage rate?”
If you have an adjustable-rate mortgage and interest rates do rise, then your monthly repayments will be higher. If you want to avoid this, you may consider searching the market to find the best deal for you.
However, as I mentioned in my previous blog about fixing your mortgage rate, the decision to fix your mortgage rate is an important one and there are many factors to consider. That’s why, if you’re considering doing so, you may benefit from seeking professional advice so that you can make an informed decision.
How would an interest rate rise affect investments?
Another group that may be negatively affected by a rise in interest rates would be investors. Investors are heavily reliant on easy access to liquidity and unfortunately for them one of the consequences of interest rate hikes is that borrowing rates also rise.
Since it becomes more expensive to access credit, many people and businesses are forced to reduce the amount that they spend. Which in turn can affect the bottom-line for many businesses, particularly ones that rely on consumption and turnover volumes.
With a slowdown in consumer spending there usually comes a slowdown in economic growth, which in turn impacts share prices and this in turn can lower the return on your investment.
If you’re concerned about how a future rise in interest rates will impact your investments, you may benefit from seeking professional advice. Working with a professional can help to alter your portfolio to minimize the impact that the change would have, giving you greater confidence and peace of mind.
Working with an advisor
As we’ve seen, while it may not be likely that interest rates will continue to rise in 2023, we cannot discount the possibility. If they do, it will have a variety of economic impacts.
To ensure that you’re ready for any potential changes, it can be useful to seek professional advice.
Working with a financial advisor can help you to manage your wealth in the most effective way, whether it’s analyzing your investment portfolio or assessing whether a fixed-rate mortgage would be right for you.
If you want to speak to a professional, use our search tool to find an advisor near you.
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