If you watch any kind of national news, it won’t take long to hear talk of interest rates and the Federal Reserve. Mysterious to many Americans, the Federal Reserve has an enormous impact on the economy; if the Federal Reserve changes its mind by a quarter of a percent, it can affect the whole economy.
You might be thinking, "This doesn’t have any impact on me." Wrong—if you have a mortgage, a credit card, or simply worry about prices rising where you shop, any decision by the Fed directly affects you.
What Does the Federal Reserve Do?
The Fed’s purpose is to keep the economy running as smoothly as possible. It watches the economic data to see if the economy is growing too slow or too fast. When necessary, it responds by controlling the supply of money and adjusting the federal funds rate (the rate at which America’s major banks loan money to each other). Most short-term interest rates on loans and mortgages are priced relative to this rate. (For related reading, see: How Banks Set Interest Rates on Your Loans.)
When the Fed Adjusts Interest Rates Down
When economic growth seems to be slowing down and the risk of recession appears, the Fed often makes it easier for banks to borrow money by loosening credit and reducing short-term interest rates. The lower interest rates encourage people to spend more money, and this spending boosts demand for goods and services. As a result, big businesses borrow money to hire new employees, expand and increase production, and stock prices of these businesses often rise as well—all from one seemingly small mathematical decision.
When the Fed Adjusts Interest Rates Up
The economy can grow too fast and inflation can soar as a result. If the Fed senses this is happening, it slows the rate of growth of the money supply. That prompts an increase in short-term interest rates and makes it more expensive to borrow. So it becomes costlier to make major purchases; fewer people buy houses, cars and other big-ticket items. As demand for these items decreases, companies produce fewer products and services and the economy slows down to a manageable pace at which inflation is controlled or reduced. (For related reading, see: What You Should Know About Inflation.)
Interest Rates and Bonds
Most bonds offer investors a fixed rate of interest until maturity. Coupon bonds state the interest rates on the face of the bond certificate. Barring default, you will receive interest payments either annually or semiannually, depending on the type of bond you hold; and some bonds don’t pay interest at all.
Any change in interest rates will affect the price of a bond. If interest rates rise, the value of a bond will decline, if they fall, the value of the bond will rise. Long-term bonds are affected by changing interest rates more than short-term bonds. That is, for the same change in interest rates, a long-term bond will experience a greater change in price than a short-term bond. (For related reading, see: Understanding Interest Rates, Inflation and Bonds.)
So what can you do to preserve your bond investment when interest rates are changing? The best thing you can do is stay informed. Find out what is happening in the economy and focus on key variables such as inflation and economic growth to help you anticipate changes in interest rates.
When interest rates are expected to rise, you might consider investing in shorter-term bonds. This helps minimize price declines since shorter-term bonds tend to be less volatile than longer-term bonds. It can also enable you to reinvest as rates move higher. When interest rates are expected to fall, many investors find it appropriate to invest in longer-term bonds to lock in higher rates and benefit from increased capital gains.
The Current Interest Rate Situation
After a year of back-and-forth of when we would see interest rates start to move, the Fed decided to raise rates in December 2016 by 25 basis points. Although the jobless rate overall is down and the headlines are raving, many workers have yet to feel the gains of an improving labor market. That being said, there is a good chance the Fed will make further rate hikes as the economy has shown largely positive economic data. Bond investors in particular will want to keep an eye on the next steps the Federal Reserve decides to take. (For related reading, see: The Federal Reserve System Affects You More Than You Might Think.)