3 Impacts of the Fed’s Rate Hike for You and Your Money.
Something you need to understand to better protect yourself in the upcoming situation.
On June 15, 2022, the Fed announced a rate hike of 75 basis points. The largest increase in nearly three decades. While the Fed and the ECB did not seem to consider the inflationary risk for several months, the situation now seems different to listen to Jerome Powell:
“We at the Fed understand the hardship that high inflation is causing. We're strongly committed to bringing inflation back down and we're moving expeditiously to do so.”
The motivation for all of this is that prices are going up. The Fed is trying to fight that with higher interest rates to reduce demand.
Even so, this may seem abstract to you, and you may have a hard time understanding what the impact of these interest rate hikes from central banks like the Fed or the ECB will be on you and your money. The first thing you need to understand is that interest rates are the main weapon of central banks to fight inflation. This one reached +8.6% in May 2022 in America.
In concrete terms, this increase means higher financing costs for banks. The latter pass them on to their clients, whether they are consumers or companies. As you will see, there are 3 main impacts to be expected from this rate hike which will continue in the coming months from the central banks.
1. More expensive borrowing and loans
For borrowers, this rise in interest rates means an increase in the cost of credit, for example, to buy a house or a car, in the case of an individual. For companies, the money needed to expand their business is also more expensive. This is why the Fed and the ECB are cautious and prefer to take it step by step: the rise in interest rates is intended to cool down the economy, but there is always the risk of the recession behind it and the rise in the unemployment rate.
The landing has to be soft, and the Fed would like to replicate what happened in 1994 in America.
For those who already have a loan, the situation may differ from country to country and from household to household: some favor fixed rates, so the rise in rates will not affect them. For variable rates, on the other hand, it is a different story.
The fact remains that for new borrowers, buying a house is now more expensive. Indeed, faced with the prospect of rising rates and the end of the ECB's bond-buying program, long-term rates have already taken the lead. In the United States, 10-year rates have exceeded 3%:
In the Eurozone, they have just passed 2% in France, for example. This is bad news for public finances - debt is becoming more expensive - but also for real estate loans which are directly linked to linear government bonds.
On the good news side, for borrowers, this rise in interest rates could slow down real estate prices. Indeed, with higher rates, some borrowers may be reluctant to proceed with their projects. The drop in demand could then cause a drop in real estate prices, which is what we are already seeing after years of constant increases.
2. Saving becomes more interesting, but it is still far from a relevant option for you
Saving is becoming more interesting. But don't expect miracles as inflation approaches 10% around the world. Banks limit themselves to the legal minimum for savings accounts and some even use means to go even lower.
The reason is simple: savings cost the banks money if they fail to lend that money to other customers over the long term. They face a penalty of 0.5% from the ECB for example. In other words: the banks have to pay interest to both the savers and the ECB. With the coming rise in interest rates, this could mean that banks can earn money again by depositing their excess savings with the ECB.
Lending money also becomes more interesting for them again. But don't dream too much: after years of being lean, they will not give back all their profit margins to savers. In any case, we should not expect an increase before the end of 2022 at best.
Even so, keeping cash beyond your emergency fund seems like a bad idea in the current inflationary environment.
3. The stock market is impacted
The impact of the Fed's rate hike is rather ambiguous on the equity market. On the one hand, higher rates may cause some investors to take profits and sell their stocks. But there is also some evidence that in the long run, higher rates do not impact stocks as negatively as they might.
In the short term, it is at the psychological level that the impact is felt the most. When the Fed's FOMC raises rates, professional traders can quickly sell stocks and move to more defensive investments, without waiting for the complex process of rate hikes to work its way through the economy.
But over the long term, the data shows that stock markets can rise in some cases when the Fed tightens monetary policy. So there is nothing irredeemable.
Dow Jones Market Data has just analyzed the 5 most recent Fed rate hike cycles to see what it has done in terms of equity market returns. Their analysis should put your mind at ease, as it showed that over these five long-term periods, the three major stock indices only fell during one rate hike cycle, from June 1999 to January 2001, during the dot-com crash.
This high inflation period with a rate hike cycle from the Fed and ECB will present you with opportunities. That's a given. But as always, you'll need to be able to take the long view to see the bigger picture. Not easy, when everyone keeps telling you about recession and stagflation.
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