The Federal Reserve just raised interest rates by 0.75% and plans to keep doing so until it is satisfied that inflation is under control, according to CNBC. What you should do about it depends on where you sit.
- Investors. If you are investing in stocks and bonds to accumulate wealth for retirement, what you should do depends on how long before you retire. If you are not retiring for five or more years, buy a stock index fund as the Fed keeps raising rates and stocks go down.
- Savers. If you are retiring sooner than that or you are already retired, put your money in an online savings account. It will not let you keep up with inflation but it will somewhat minimize the damage.
- Borrowers. If you must borrow money, pay off as much of your debt as you can, try to convert your floating rate debt into fixed rate. If you borrow on your credit card, move as much as you can into the lowest interest rate card you can find.
Why Is the Fed Raising Interest Rates?
Today the Fed raised its federal funds rate up to a range of 3% to 3.25%, the highest it has been since early 2008.
The Fed has done what I think is an excellent job of communicating its strategy which is to keep raising interest rates aggressively — eg, by 0.75% at each meeting — until inflation goes way down.
And there is a long way to go. Specifically, with August inflation rate at 8.3%, the Fed will be raising rates aggressively until inflation is clearly heading down rapidly to its target rate of 2%.
Indeed, I found it surprising that the Fed said that it will stop raising interest rates next year. But it did just that —[signaling] the intention of continuing to hike until the funds level hits an end point, of 4.6% in 2023. That implies a quarter-point rate hike next year but no decreases,” according to CNBC.
My surprise is that the Fed seems to think that it will be enough to tame inflation.
Meanwhile, the Fed expects its interest rate increases to push the economy closer to a recession. As CNBC reported, that means the Fed expects GDP growth to slow to 0.2% for 2022, rising slightly in the following years to a longer-term rate of just 1.8%.
Meanwhile the Fed expects its rate increases to throw people out of work. Fed officials expect the unemployment rate to rise to 4.4% by next year from its current 3.7%. “Increases of that magnitude are often accompanied by recessions,” noted CNBC.
And the Fed now thinks that inflation — excluding volatile food and energy prices — will not decline — from its current 4.5% to around its target — hitting 2.1% — until 2025.
What Long Term Investors Should Do
Since rising interest rates mean lower stock prices, it is quite painful for me that the Fed will keep hiking interest rates.
To make my pain go away, I could sell all my stocks so they would stop going down. But as someone who believes that stocks outperform other investments over the long run, I am doing nothing to alleviate that pain.
Instead, I keep investing in stocks every month as they go down. That strategy makes sense for long-term investors who have the time to suffer over the next few years until they can enjoy the inevitable recovery of stocks.
That will surely happen once inflation goes below 2% and stays there for a few quarters. At that point, the Fed will stop raising interest rates and start cutting them.
In my view, there is no reason to own bonds until it is clear that their prices will go up. And as long as the Fed remains poised to increase interest rates, the risk of holding bonds is greater than the potential reward.
What Savers Should Do
Those who need to maximize their income from investments and savings should look for savings accounts that are paying higher rates — albeit way below the Fed Funds rate.
A case in point is Goldman Sachs’s Marcus. According to the Wall Street Journal, “Six months ago, a $1,000 account [there] would net 0.5% in interest. Now, the same account is offering 1.9% in annual percentage yield.”
Online accounts — due to lower overhead expenses — can pay even higher interest rates, According to CNBC, “top-yielding online savings account rates are as high as 2.5%, much higher than the average rate from a traditional, brick-and-mortar bank.”
Another option is government bonds. Yields on 1-year Treasury bills and the 2-year note are “hovering at 4%, rising from near 0% a year ago,” noted MarketWatch.
Unfortunately, these interest rates fall way short of the rate of inflation. So savers are inevitably going to suffer a loss in real spending power.
What Borrowers Should Do
Meanwhile, savers’ pain is the banks’ gain. That’s because interest rates on credit cards, mortgages and car loans are going up right away.
How so? As the Wall Street Journal wrote, “Before the Fed’s move, the average fixed rate on a 30-year mortgage recently rose to 6.02%, from 4.16% the week of March 17, and additional rate increases would likely push mortgage rates even higher. “
Credit card interest rates are rising and likely to continue to do so. “The credit card annual percentage rate (APR) rose from “around 16.17% in early March to more than 18% in September.” That rate is inevitably rising.
Meanwhile the average APR on a five-year car loan has risen over the past six months from 3.98% to 5.07%, according to Bankrate.
Borrowers should try to pay off their debts as much as they can and lock in the lowest rate they can find.