Who’s afraid of the Big Bad Fed?

Last week the Bureau of Labor Statistics released the inflation numbers for January 2022. At an eye-popping 7.5% (annualized), last month’s inflation rate is the highest in 40 years. Ouch.

So now everyone’s talking even more about the prospect of the Fed “raising rates.” But what does that mean, and how serious is it really? 

Does Jerome Powell (the current Federal Reserve chair) go into a bunker somewhere to push a big red button that magically reduces inflation and could tip us into a recession if he holds it down too long? 

Well, no. Long story short, the Fed can effectively push banks’ interest rates up or down (though it’s more involved than just pushing a magic button). This encourages more or less lending in the financial sector which, in turn, leads to countless trickle-down effects.

A bit of an intense infographic, yes – but it’ll make more sense if you have the full picture.

What impact does the Fed Funds Rate have on me?

To truly understand what these “rates” are and how the Fed controls them, you’ll want to check out this week’s blog post. But for now, let’s cut to the chase and discuss why you should care: that is, the changes you should expect if and when rates rise.

  1. Borrowing will get more expensive  –  Mortgage rates, car loans, private loans, etc. will have higher interest rates, causing the loan as a whole to be more expensive for the borrower.
  2. Savings rates will increase  –  As rates rise, savings accounts and other “safe” investments like bonds will actually yield meaningful returns, which means spending rates and economic activity could decrease as a result.
  3. Bank stocks will go up  –  Rising interest rates mean that banks can charge more for loans. Which is how banks make their money. 
  4. Smaller “growth” stocks will go down  –  Firms that rely on a lot of borrowing to fund their operations (i.e. up-and-coming “growth” firms) will fare worse than companies with well-established cash flow and solid balance sheets (i.e. “value” firms). 
  5. Bond values will drop –  This one is a bit tricky, and we unpack the reasons for it a bit more in the aforementioned blog post. But it is a thing, historically speaking, as the below graph indicates:

Note also that the impact of #5 on your bonds specifically will depend on two other factors:

  1. The difference between prevailing interest rates and the particular interest rate of your bond
  2. Your bond’s “duration,” or how much time is left until it reaches maturity.

As you can imagine, interest rates have tons and tons of other potential effects beyond these. For example, the student debt burden is a whole other post unto itself (probably even a book, for that matter). And like everything else in the world of finance, whether these effects are a good or bad thing will vary wildly depending on your circumstances.

So unfortunately, I can’t say how you as an individual should prepare for the likely – but technically not certain – prospect of interest rates going back up in the near future. But I can help you stay informed, even if that’s just with a little five-minute read like this one.