The good and the bad of higher interest rates
Q. I heard that the rate hike by the Federal Reserve is good? Why is that good?
A. Are higher interest rates a good thing? It all depends.
Higher rates are good for savers and retirees. Higher rates are bad for borrowers, such as home buyers, car buyers and big corporations, said Bernie Kiely, a certified financial planner and certified public accountant with Kiely Capital Management in Morristown.
Kiely offered the recent history of interest rates:
Back in 2006 and 2007, the two-year U.S. Government bond was paying about 5 1/4 percent. On Oct. 9, 2007 the stock market hit its peak. Over the next 17 months, the S&P 500 gave up 56.8 percent of its value, Kiely said.
Kiely said in order to try to slow down the free falling economy, the Federal Reserve Board — the Fed — used the only tool it has in its tool belt.
“The Fed directly controls what banks have to pay in interest when they have to borrow from the federal government,” Kiely said. “The Fed controls the Fed Funds Rate. When the Fed raises the Fed Funds Rate, it slowly trickles through the system and eventually has an effect on all other interest rates.”
So in 2008, Kiely said, the Fed started cutting the Fed Funds Rate. By 2011, the two-year rate was at one-tenth of a percent. Today, the two-year bond is up to 0.9351 percent — less than one percent.
So what has been the effect of near zero interest rates?
Kiely said if you are retired and living off the interest of CDs, you are really hurting. If you are still working, the fixed income portion of your 401(k) is not earning anything.
But you have a paycheck, and mortgage rates are low. According to Bankrate.com, 30-year fixed rates are 3.75 percent, and you can also get extremely low rates on car loans.
The lower rates make a difference to the wallets of consumers.
“When I purchased my first home back in the last century, I paid 8.75 percent,” Kiely said. “That is a five point difference. On a $250,000 mortgage, that’s $15,500 per year in interest, $1,041 more per month.”
During the six-and-a-half years since the market’s 2009 bottom, the S&P 500 is up 204 percent, Kiely said. So low interest rates have had a mixed effect.
When rates start going back up, what effect will it have on the economy?
“Many pundits say the sky will fall,” Kiely said. “Car sales will stop, home sales will slow down and the stock market will go into the hopper.”
Kiely said he’s more of an optimist.
“I remember when the 30-year government bond paid 8 percent — back when I had an 8 3/4 percent mortgage. The economy did just fine,” he said. “Now the 30-year bond is paying 2.96 percent, up from its 2.22 low. If the 30-year bond goes to 5 percent, last seen in 2007, the economy will thrive.”
What about the stock market?
Kiely said when the first uptick in rates occur, the market usually has a knee-jerk reaction, and then it calms down.
“Keep one thing in mind: this bull market started on March 9, 2009. We just had a 12.35 percent market correction on Aug. 25 of this year,” Kiely said. “Since then, the market has been going sort of sideways. The 12.35 percent correction is now a 3.9 percent correction. The market may use the rate increase as an excuse to drop 20 percent. If it does so, it’s because we are due. Bull markets don’t go on forever.”
Altair Gobo, a certified financial planner with U.S. Financial Services in Fairfield, offered five potential benefits to higher interest rates.
1. Higher interest rates on savings accounts: Since 2012, the average 1- to 5-year CD rate has been less than 1 percent, Gobo said. Higher than average rates can be found, but don’t expect to hit the jackpot. Higher interest rates on CDs and other savings accounts should benefit, in particular, those living on fixed income.
2. More lending: As interest rates rise, banks may be more willing to lend, Gobo said. If lending increases, it could be a catalyst for the economy overall.
3. Possible “boost” to the stock market: Gobo said shying away from the Fed’s monetary policy, stocks could return the focus to market fundamentals. “As long as the Fed raises rates carefully and slowly without spooking the market, we could see a long-term benefit,” he said.
4. Real estate: Higher Fed rates eventually lead to higher mortgage rates. “People who have been contemplating a home purchase may be encouraged to buy sooner if they think rates are going up,” Gobo said. “In the short term, this could be good for the real estate market.”
5. Stronger dollar: It is possible that a Fed rate hike could help further strengthen the dollar. “Those who are travelling may see more buying power as the U.S. dollar continues to gain strength against foreign currencies including the Euro, Yen, Pound and Swiss Franc. Everybody loves a bargain,” Gobo said
Email your questions to Ask@NJMoneyHelp
Karin Price Mueller writes the Bamboozled column for The Star-Ledger and she’s the founder of NJMoneyHelp.com. Click here to sign up for the NJMoneyHelp.com weekly e-newsletter. Like NJMoneyHelp.com on Facebook and follow it on Twitter.