What Does the Federal Interest Rate Mean To You?

It’s overwhelmingly expected that the Federal Reserve will raise interest rates at its quarterly meeting this week, bumping the currently 0% prime up by 0.25% in the wake of increasingly positive news out of the U.S. economy.

This will be the Fed’s first increase since 2008 when it instituted emergency measures in response to the financial crisis. Although the recession formally ended in 2009, the bank has kept interest rates at their historic low in response to a sluggish and often criticized recovery. Most notably, the failure of wages to grow amid falling unemployment.

In the face of this struggling wage growth, Federal Reserve Chairman Janet Yellen kept interest rates low over the past seven years in order to a policy of easy money for business investment.

This has been in service to what economists refer to as the “dual mandate” of the Federal Reserve: balancing low inflation against high employment. Reduced interest rates can spur employment due to how easily businesses can get money to hire and spend, and after a certain point this puts upward pressure on wages as the employment market becomes more competitive.

Counter-cyclically, however, as wages increase faster than the availability of goods and services (generally measured by wage growth set off against GDP), prices will begin to rise in response to the escalated relative purchasing power of consumers. This creates a wage/price inflation cycle, which the Fed attempts to forestall by lowering interest rates when the employment market begins to look too strong.

Despite steady job growth, stagnant wages have concerned economists at the Federal Reserve. Without that key step of the wage/price spiral, and therefore little evidence of pending inflation, the Federal Reserve has opted to keep rates low far longer than ever before.

It has been an historically long run of equally historically low interest rates, creating what many experts call brand new territory.

“Nothing about this post-crisis period has been common,” said Pat Maldari, a senior investment manager with Aberdeen Asset Management. “We do think that in this [coming] cycle it will be different, and it will be different because nothing about this post-crisis period has been consistent with history.”

Although all indications are that the Fed only plans to raise interest rates by a small amount, one quarter of a percent or “25 basis points,” the bigger concern among investors and banking specialists is what this signals about the Fed’s long term intentions.

As Maldari described it, steering the economy is like “turning a battleship.” It can take months before a decision trickles down to show up in wage, investment and hiring data. As a result the central bank tends to move cautiously in the absence of crisis, making small adjustments and waiting to see the results. Real change comes in increments over time. If the Fed bumps rates further in response to an increasingly strong economy it will take place over the course of 2016.

“The Fed will have made a spectacular hash of things if they don’t hike this week,” said Asset Management Investment Manager Luke Bartholomew, also with Aberdeen Asset Management. “All recent significant communications have pointed towards a hike and the data has been strong enough to confirm this expectation… so the hike itself is unlikely to cause a big market reaction. But there are still important questions around how the Fed manages the market’s expectations about what the future holds.”

“[It’s] all about the speed at which rates rise and where they settle,” Bartholomew continued.

The real question on Wall Street is not whether rates will go up but how far and for how long.

Over on Main Street the questions hit closer to home as individuals wonder what this news might mean for their employment and investment prospects. It’s a question that many economists answer reluctantly given how long it takes rate changes to play out, however the overall (and intended) effect is to slow down the economy.

“The Fed watches the labor market closely when they’re designing policy,” said Andrew Chamberlain, chief economist with the employment site Glassdoor.“But the link the other direction, from monetary policy to the labor market, is a lot more complex. So almost certainly the Fed’s going to make a move on interest rates Wednesday, and when they do, it does not have a direct effect on the labor market.”

The new interest rates will make capital slightly more expensive, slowing down investments and borrowing on the part of business. As a downstream consequence economists such as Chamberlain expect hiring to slow down, for the same reasons that reducing interest makes the employment rate pick up.

“The easiest way to think about the effect on the economy of an interest rate change is to bust it into its separate parts,” Chamberlain said. That means consumption, investment, net exports and government spending.

Business investment slips as money gets more expensive, as do net exports since increased interest rates make the U.S. dollar a more attractive investment vehicle and therefore more expensive. (A stronger dollar makes American goods and services more expensive internationally.) Both of these factors will hurt long term employment prospects, forcing the labor market to increasingly rely on business confidence and consumer spending instead of access to inexpensive capital.

Still, the link between interest rates and employment remains a highly tenuous field.

“There’s this problem in macroeconomics that many of the relationships we observe empirically, they tend to break down when we make changes,” Chamberlain said. “I don’t know of any research that plainly identifies a 1-to-1 link between the federal interest rate and wages, or the federal interest rate and unemployment.”

The connection is there. How tightly, however, remains an unmeasurably quantity.

The same can be said for individual investments and debt which suffer from the same long term and tenuous predictions. The most immediate impact that consumers will feel from a rate change will be communicated in variable interest debt such as certain credit cards, mortgages or student loans.

Even that will only move a fractional amount after this week’s projected rate hike. Investment advisors such as Bill Fink, head of credit management with TD Bank, urge that in the immediate future this rate change will have negligible effects on consumer debt and investments.

Fink said that consumers should focus on the Federal Reserve’s long term strategy before making any long term decisions. While a small, immediate bump to the interest rate will have little discernible effect on the average investor, a trend of increases to the prime interest rate will make debt more expensive and long-term investment vehicles more valuable.

“If you’re borrowing as a consumer, I would look at now,” Fink said. “Rates are at an historic low, even with a 25 basis point increase. If you have a need for debt and it’s productive debt I would look at getting it now.”

“On the other side if you are a consumer and you have liquid funds, now is not the time to lock those in,” he added.

Products with fixed or long term yields will only get more valuable if the Federal Reserve continues to increase rates, as it’s widely expected to do, making now a strong time for potential investors to hang on to their liquidity.

Officials at the Federal Reserve have repeatedly stated that they intend to increase rates gradually, and Yellen has said that she wants confirmation of inflation above the Bank’s targeted 2% before making any aggressive moves.

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