NEW YORK (TheStreet) -- Speculation regarding interest rate decisions by the Federal Reserve has resulted in many myths about interest rates bubbling to the surface. Some of the most common fallacies about the Fed's interest rate decision have not only prompted many debates but also raised new concerns amongst investors. Since prudent investment decisions are based on our fundamental understanding of financial markets, let's eliminate some of these misconceptions that could be deteriorating the value of our investments.Myth 1: The Fed directly controls all the interest rates.
Reality: The Fed directly controls only one rate known as the Fed Funds rate.
The Fed has a direct control over only one rate and that is the Fed funds rate, which is an overnight rate charged between banks to maintain minimum reserve requirements. Changes in Fed funds rate affect short-term interest rates, particularly the yield of money markets, bank savings accounts and floating rate loans, but long-term interest rates may remain little affected by the Fed funds change. This is because interest rates like those of 10-year treasury bonds and 30-year mortgage are determined by many additional factors, like supply and demand of capital, expectations of growth prospects and inflation. The long-term interest may change only when the Fed funds rate significantly affects any of its contributing factors. While short-term interest rates and Fed funds rate may have a stronger link, the connection with long-term interest rates gets weaker with the length of time.
Myth 2: Interest rates should be kept low so that increased consumer spending can lift the economy.
Reality: A balanced consumer spending and personal savings are both crucial to a healthy economy and required to control the pace of an economy. Consumer spending should not be promoted at the cost of savings and investment.
Spending is an important component of the U.S. economy and makes up 70% of U.S. economic output. During recessions, spending needs to be triggered to boost consumer confidence and stimulate demand in the declining economy (decline in Fed rates). But, interestingly, the first signs of recovery come from corporate spending and not consumer spending, in the form of industrial production, capital formation, and construction. While consumer spending helps in strengthening a failing economy, high national savings help fund more national investments once the economy has stabilized. Excessive consumer spending can lead to consumers saving less, leading to depletion of funds available for investment in the economy and eventually cutting economic growth. In contrast, if there is high savings only, then the economy may remain stagnant. The crucial reason a consumer-dominated economy may not be desired is that consumer spending may crowd out investment spending, which is also a key factor of long-term growth. However, too much of spending or saving can be a concern for the economy. An interest rates change by the Fed helps in maintaining a moderate balance between consumer spending and savings and ensures that inflation is at target levels.
Myth 3: The economy will fall apart if interest rates go up.
Reality: A hike in interest rate may be needed to prevent overheating of the economy.
The primary forces that drive interest rates are supply and demand that are influenced by inflation and monetary policies. When the economy has shown strong signs of improvement, policymakers feel the need to raise Fed funds rate in order to prevent inflation from rising. High interest rates help to limit financial bubbles, while channelizing capital towards more productive sectors like infrastructure and development of new technologies. Similarly, if low interest rates are kept for too long then they can hurt savers, particularly retirees and pensioners, by giving them little returns on their savings.
However, the current indicators of the U.S. economy are complicating the Fed's decision on whether interest rates should be raised or remain unchanged. Since the country is facing inflation well below Fed's own target rate of 2%, low agricultural commodity prices, disappointing job growth and absence of significant wages, many economists are of the opinion that the Fed should avoid any hikes in September. Nobel Laureate, Joseph E. Stiglitz said, "The usual argument for raising interest rates is to dampen an overheating economy in which inflationary pressures have become too high. That is obviously not the case now."
But, supporting the interest rate hike, Andreas Utermann, chief investment officer at Allianz Global, feels that interest rates have been kept close to zero for a while and near zero interest is "counterproductive" harming fixed capital investments, which remain at an all time low.
Myth 4: Higher interest rates are bad news for the bond market.
Reality: The influence of interest rates depends on the position of the bond on the yield curve.
Before dismissing the myth, it is important to understand that interest rates, inflation expectations and bond prices are correlated. Bonds are considered the safe portion of a diversified portfolio because they hedge equity risk. The myth that high interest rates will hurt all bond rates may only be slightly true. While interest rates do influence short-term bonds (3-to-6 months), the story maybe slightly different for long-term bonds. This is because long-term interest rates for a longer duration of bonds depend mostly on expectations of future levels of inflation and investors' perception of the domestic and global economy. If the future inflation is expected to rise, then it could eat into the profits of treasury bonds as high inflation erodes the purchasing power of future cash flows of bonds.
Interestingly, a lot depends on the position of the bond on the yield curve (short end or long end). Fed tightening may affect mostly front or short end of the yield curve since the long end is driven by inflation, that is relatively below fed's target inflation rate. According to Collin Martin, director of fixed income strategy for Charles Schwab & Co. in New York, "Low inflation will continue to keep the long-term yields down." In addition to this, through increased demand and a strong dollar foreign investors may consider U.S. Treasuries as a smart bet in comparison to their own local alternatives that carry low interest rates.
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- Why the Fed should be raising rates now.