Weekly Wire Special Edition: Interest rates

Interest Rates

Just about everyone knows the story of The Tortoise and the Hare and its accompanying lesson:

Slow but steady wins the race.

Judging by their actions over the years, the Federal Reserve knows the story, too.

On December 14th, the Fed raised its key interest rate for the first time in a year. It was a relatively small increase of only 0.25%, taking the rate from 0.5 to 0.75%.1 Like the tortoise, the Fed has been extremely slow to raise interest rates—in fact, this is only the second time they’ve done so in the past decade.1

Interest rates are an important part of our nation’s monetary policy, and they can have a profound effect on the economy. But unless you study this sort of thing for a living, it can be difficult to understand what all the fuss is about. What is the Fed’s “key interest rate” anyway? Why does it matter if the Fed raises rates, and why were they so low to begin with? And why exactly is the Fed taking such a tortoise-like approach to raising rates?

This letter will answer some of those questions.

What is the Fed’s key interest rate?

When the media talks about the Fed raising its key interest rate, they are usually referring to the Federal Funds Rate. This is the interest rate at which banks lend funds to each other on short-term (overnight) loans. The higher the rate, the more expensive it is for banks to borrow money from other banks.

The Federal Funds Rate is important because it can impact many other rates. For instance, if banks have to pay a higher interest rate to borrow money, they will often raise their own rates to compensate, affecting mortgage loans, car loans, business loans, etc. For this reason, economists keep a close eye on the Federal Funds Rate because it has broader implications on the overall economy.

Why have interest rates been so low for so long?

The reason the Federal Reserve kept rates so low for so long was to stimulate our post-recession economy. Lower rates make it easier for people to buy homes. It means more businesses can borrow money, and by extension, add more jobs. In short, lower rates allowed people to pump more money into the economy. This, of course, equals growth.

Why has the Fed been so slow to raise interest rates … and why are they doing it now?

Let’s go back to The Tortoise and the Hare.

In Aesop’s classic fable, the Hare gets off to a lightning-quick start. But soon he tires and decides to take a nap, reasoning that his opponent will never catch up. The Tortoise, meanwhile, keeps plodding along and eventually wins due to sheer doggedness.

The Fed has done its best Tortoise impression because the economy has moved like the Tortoise. While lower interest rates have helped stimulate growth, that growth has been slow. From the Fed’s perspective, they did not want to raise rates too quickly and run the risk of killing said growth before it even had a chance to take off. “The more haste, the worse speed,” as the proverb goes.

To date, the economy has never really “taken off.” But it has enjoyed the same sort of progress as the Tortoise: plodding, but consistent. Slow, but dogged. The United States has added jobs for 74 consecutive months, and the unemployment rate is now down to 4.6%, the lowest since 2007.2 Inflation, meanwhile, has finally started to rise, albeit tepidly, up from 1.3% in September to 1.5% now.1 These are the key statistics the Fed looks at when deciding to whether to raise interest rates, and right now, those

stats are saying that the US economy is steady enough to take the training wheels off … but slowly, slowly. Because slow but steady wins the race.

What will the Fed do next?

It’s impossible to answer that question, because so much of it depends on what Congress—and to a lesser extent, President-elect Trump—decides to do.

Here’s a basic rule of thumb: if the Fed believes the economy needs to “speed up” (grow at a faster rate) then it will keep interest rates low. If it believes the economy needs to “slow down” (because it’s growing too fast, at a pace both unstable and unsustainable) it will likely raise interest rates. Right now, many analysts believe that Republican-dominated Washington will seek to cut taxes and spend more on infrastructure in 2017. If that happens, the economy may well grow more quickly, elevating inflation along with it. As a result, the Fed may feel the need to raise interest rates at a faster clip so that neither expands too quickly.

If growth remains slow, however, or if something happens to “shock” the economy, the Fed may decide to keep interest rates low.

What does this news mean for us?

To restate: the recent rise in interest rates is very small. Its direct impact will mainly be felt by people looking to buy a home, take out new student or car loans, or who are accumulating credit card debt. That’s why at Minich MacGregor, we feel you should look at the news from a slightly different angle:

For years now, pundits and politicians have argued over the Federal Reserve. Some people feel the Fed has raised interest rates too slowly. Others feel that it’s still too soon to raise interest rates at all. Some want the economy to grow at a much faster pace. Others feel that too much growth too soon could have negative consequences.

It’s a complex topic, because interest rates themselves are complex. It’s an issue with a lot of nuance, and for the most part, it’s completely out of our control.

So here’s how we would look at this news: by remembering the lesson of The Tortoise and the Hare.

When it comes to investing, it’s better to focus on what we can control than on what we can’t. We can’t control what the Federal Reserve does. We can’t control what the economy does. But here’s what we can control:

As investors, do we want to be the Tortoise … or the Hare?

In Aesop’s fable, the Hare is swift, but also lazy. Confident, but to the point of arrogance. The Tortoise, meanwhile, is deliberate and focused.

Less disciplined investors tend to react to news like this by emulating the Hare: dashing around, trying to react to short-term events, buying or selling based off headlines, thinking the race can be won right out of the gate. My recommendation? Act more like the tortoise. We have an investment strategy. Let’s stick to it. We have investment goals. Let’s focus on those, not on Washington or New York. We should always be aware of what’s happening in the world, but we shouldn’t stress too much about it—because the world will likely look very different tomorrow.

So while interest rates may change and the economy evolve, and the markets move up or down, we’ll continue to act like the Tortoise.

Because slow but steady wins the race!

P.S. If you have any questions about interest rates, the markets, or anything else, please feel free to contact us. We are always thrilled to speak with you! Also, if you have any friends or family members who seem confused about interest rates or concerned about what this news means to them, please feel free to share this article!

Sources:

1 Jim Tankersley, “Federal Reserve raises interest rates for second time in a decade,” The Washington Post, December 14, 2016. https://www.washingtonpost.com/news/wonk/wp/2016/12/14/federal-reserve-expected-to-announce-higher-interest-rates- today/?utm_term=.8b150892ef2d

2 Patrick Gillespie, “Finally: Fed raises rates for first time in 2016,” CNN Money, December 15, 2016. http://money.cnn.com/2016/12/14/news/economy/federal-reserve-rate-hike-december/index.html