What’s the impact on investors when the Federal Reserve raises interest rates?
Editorial staff, J.P. Morgan Wealth Management
- When the Federal Reserve increases interest rates, policymakers are aiming to make borrowing more expensive.
- Rising interest rates may encourage people to save more.
- Less money circulating in the economy can translate to slower economic growth and less inflation.
- Rising interest rates are generally not welcomed by stock investors, although there are certain sectors of the stock market that could benefit.
- A Fed interest rate hike may exert downward pressure on the price of existing bonds.
The Federal Reserve raised interest rates in 2022 and 2023 after a prolonged period of low interest rates. While you might have noticed the volatility surrounding markets around that time, you might not have understood why investors reacted so strongly.
We’re here to explain what rising rates could mean for investors like you. But before we do, let’s take a step back and dive into the Fed and its role as the U.S. central bank.
The Fed and its mission
The Federal Reserve, aka the Fed, is the de facto central bank of the United States. It is similar to the other major global central banks, such as the Bank of England (BoE) and Bank of Japan (BoJ), in that its mission is to keep the U.S. economy operating at peak efficiency. With this as its mandate, the Fed focuses on employment and inflation.
The Fed’s operating structure is different from other central banks because the framers of the Federal Reserve Act of 1913 did not want to grant so much power to a single entity without putting some checks in place. So they came up with a system that is composed of:
- A Board of Governors that is independent of the federal government, even though the seven members have to be nominated by the president and confirmed by the Senate.
- Twelve semi-independent Federal Reserve Banks that represent a particular geographic area of the U.S., which are the operating arms of the Fed.
- The Federal Open Market Committee (FOMC) that consists of 12 people: seven members of the Board of Governors, the Federal Reserve Bank of New York’s president and four other Federal Reserve bank presidents.
Of these, the FOMC is in charge of setting monetary policy. In other words, the members of the committee vote on whether the target range for the monetary policy rate is appropriate to achieve the Fed’s mandate of maximum employment and price stability. This target rate, also known as the federal funds rate, is used by banks and other depository institutions to lend money to each other.
The relationship between the fed funds rate and economy
To recap what we just stated, the Fed is concerned with anything that threatens the U.S. economy’s ability to function as smoothly as possible. If inflation appears to be getting out of hand, then the Fed may decide to raise interest rates (i.e., the fed funds target rate) to contain it, and if the economy is mired in a recession, the Fed may lower rates to spur economic activity.
Like we said before, the fed funds rate acts as a guidepost for the interest rates that depository institutions (e.g., commercial banks) charge each other for overnight loans. Oftentimes, banks have to resort to these loans to comply with the liquidity requirements set by the Fed.
While the actual fed funds rate is the reference, the effective fed funds rate is the average of all the actual overnight loans. This rate is important because it affects other market rates and loans. By targeting the fed funds rate, the Fed can directly impact interest rates across the U.S. economy and indirectly influence global interest rates as well.
Get up to $1,000
When you open a J.P. Morgan Self-Directed Investing account, you get a trading experience that puts you in control and up to $1,000 in cash bonus.
So… what is inflation?
Inflation is an economic phenomenon where there the prices people pay for goods and services increase over time. This results in a decrease in the consumer’s buying power. Say the cost of product X was $10, but it has now risen to $12. If the consumer is paying more for X, and if they aren’t making more money, they have less to spend on something else they may need or want.
What happens when the Fed raises interest rates?
The Fed raised interest rates several years ago because inflation had risen substantially, driven in part by supply-chain issues that resulted from the pandemic. By raising the target for the fed funds rate, the Fed aimed to increase the cost of credit and make borrowing more expensive. This was meant to discourage people from borrowing aggressively to pursue opportunities, such as consumer electronic products. The rate hikes were also intended to encourage more people to save, as banks’ savings rates also increased. The net goal was less money circulating in the economy, which can result in lowering economic activity and reducing inflation to a level the Fed deems manageable.
How do rising rates impact stocks?
As is often the case with investing, a straightforward answer to a question like this doesn’t exist. Unfortunately, the relationship between rising interest rates and stock prices is murky, even for experienced traders.
Generally speaking, rising interest rates are not welcomed by stock investors. The reasoning is that if the cost of borrowing increases, then companies may not be as eager to take on the added financing costs to grow their businesses. This may result in lower revenues, which would affect profitability. This lowering of the expectations for future returns might cause investors to sell stocks in the hopes of finding a better return for their money, which leads to lower stock prices.
However, there are certain stock market sectors that could outperform others as interest rates rise. That’s not to say that they will rise, just that they may not fall as much. For example, financial institutions, like banks, often have the opportunity to be quite profitable in a higher interest rate environment.
How do rising rates impact bonds?
The price of a bond is inversely related to interest rates, so an interest rate rise will mean an equivalent drop in the face value of bonds. A Fed interest rate hike will typically result in immediate downward pressure on the price of existing bonds. The reason for this is that newer bond offerings may offer higher coupon rates (i.e., the ratio between the interest the bond pays and its price), resulting in higher payments to reflect the rise in rates. Consequently, the current bonds will have to fall in price so that their coupon rate is in line with that of the newer bonds.
Fed tightening is likely to impact investors whose portfolios are more exposed to bonds, like those investors who are nearing retirement. It is advisable that they speak with their financial advisors to map out the best way to navigate the risks posed by a rising interest rate environment.
The bottom line
As an investor, it’s wise to keep an eye on the Fed’s policy decisions and weigh any potential impact on your portfolio. When the Fed raises interest rates, the increase in borrowing costs can translate to slower economic growth and less inflation, as well as potential pressure on the stock market and a possible decline in existing bond prices. It might be worth consulting with your financial advisor about how you can adapt your strategy and portfolio to the current rate environment.
Editorial staff, J.P. Morgan Wealth Management
