One of the Federal Reserve’s main tools to combat inflation is rate hikes. When the central bank raises interest rates, borrowing costs increase, which discourages lending and spending and can stifle inflation.
Technically, the Fed can only manipulate one rate: the federal funds rate. When the Federal Open Market Committee (FOMC) sets a target range for the funds rate, it influences the interest rates commercial banks charge each other for overnight loans. (Generally, a single Fed rate hike raises interest rates by 25 basis points, or 0.25%).
However, the funds rate directly and indirectly links to several others, like the prime rate, which is the basis for several types of loans. As such, moving the funds rate often leads to rippling economic impacts.
For instance, as the price of borrowing goes up, businesses and consumers take out less debt, including mortgages, auto loans and even credit cards. At the same time, the rate on savings accounts rises, encouraging more savings.
Between these two forces, consumers are less likely to spend their discretionary income or upgrade their car or house. And as demand for goods slows down, supply increases, which can depress inflation.
Generally, rate hikes lead to:
But Fed rate hikes don’t just hit consumers – they also influence the investment markets. For instance, because bond prices move inversely to interest rates, higher rates can negatively affect fixed-income investors.
When it comes to stocks, rate hikes tend to hit indirectly. And while the stock market generally slumps in response to rate hikes, it’s not true in every instance.
For example, rate hikes tend to bode well for:
But broadly speaking, high interest rates often lead to a dip in corporate profitability as consumers assume less debt and spend less capital. In turn, a company’s stock may drop if lower revenues spook investors come earnings season.
Rate hikes often affect market psychology, or how investors feel about the stock market. When the FOMC announces a rate hike, traders may abandon ship for more defensive positions. And while it’s tempting to sell out for greener pastures now, rate hikes typically take months to wind through the economy.
For most investors, sticking with your long-term strategy is more likely to yield the best results. With a robust asset allocation, strong diversification and the right risk-return tradeoff, you can glide through rate hikes with ease.
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