The Fed Finally Raises Interest Rates

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December 17, 2015 5:00pm NYSE:TBT NYSE:TLT

Janet-YellenBob Ciura:  Throughout 2015, whether or not the U.S. Federal Reserve would increase interest rates for the first time since 2006 had been debated back and forth ad nauseam. Now we finally have our answer.

fed raises interest rates

The Fed did indeed raise interest rates on Wednesday, citing a strengthening U.S. economy, which is now sound enough to support itself off of the previous near-zero interest rate policy.

And yet, in the Fed’s statement detailing the rate hike, the central bank struck a tone of dovishness. Going forward, the Fed is likely to take a very gradual approach to future rate hikes.

Fed Takes Liftoff

The Fed decided to raise the federal funds rate, which is the benchmark rate that banks charge each other for short-term loans. The new target will go from the previous range of 0%-0.25% to a new range of 0.25%-0.5%.

This marks the first rate hike since June 2006. Since then, the Federal Reserve embarked on a steady path of extreme monetary easing, including quantitative easing programs and lowering interest rates. This was done in an effort to resuscitate the U.S. economy, which crashed in 2008 due to the financial crisis.

By finally raising rates, the Fed is signaling that the U.S. economy is now strong enough to sustain higher interest rates. That is essentially a good thing for the U.S. – the economy no longer needs to be on the Fed’s monetary life support.

Raising interest rates is appropriate in the eyes of the Fed. The housing and stock markets have recovered strongly since the dark days of the Great Recession. And the U.S. labor market has neared the Fed’s stated target of 5% unemployment, which the central bank generally views as the marker of full employment.

However, investors should temper their expectations for future rate hikes going forward. While the Fed noted the strengthening U.S. economy, in its ensuing press release it also referenced the lack of inflation in the economy. Furthermore, the Fed stated that its general monetary policy will remain accommodative in the future. That means the Fed remains committed to doing whatever is necessary to keep the economy afloat should the U.S. enter another economic downturn.

Deciphering the Winners and Losers

Among the primary beneficiaries of the Fed’s decision to raise the fed funds rate are banks, and more broadly, the financial sector.

Banks, insurance companies and other financial institutions will benefit greatly from higher interest rates. That’s because financial firms earn a spread between the interest paid on deposits versus the interest earned on loans. The bulk of loans are generally longer-term in nature (think auto loans and home mortgages), while deposits are usually parked in short-term vehicles like savings accounts and certificates of deposit. As a result, the net interest margin earned by banks tends to increase when rates rise. In addition, consumers with savings in the bank are likely to see an uptick in the interest they earn.

Among the losers are companies and consumers who rely heavily on debt. For example, within the stock market, real estate investment trusts (REITs) and utilities are expected to be among the biggest losers. That is because these kinds of companies are highly leveraged. They require long-term debt to finance their massive asset bases. As a result, higher interest rates will elevate their financing costs and cause their earnings to suffer from higher interest expenses going forward.

Still, from a broad perspective, rising interest rates are generally a good thing for the U.S. economy.

This article is brought to you courtesy of Bob Ciura from Wyatt Research.

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