Ask the investor
Q: Why does the Federal Reserve keep interest rates so low?
A: The Federal Reserve recently met and voted to keep short-term interest rates (known as the federal funds rate) at the historically low range of 0.25 percent to 0.5 percent. Short-term rates have been ranging under 1 percent now for close to a decade, and many on Wall Street, as well as Main Street, are wondering when rates will begin to normalize.
The Federal Reserve (aka the Fed) was established by Congress in 1913 in response to a series of financial panics and the belief that some control and regulation of the monetary system was necessary and beneficial. The Fed was given two primary tasks, often referred to as the “dual mandate.” Those are encouraging employment and controlling inflation.
These dual objectives require a delicate balancing act. If the Fed is overly zealous in promoting employment through stimulating the economy, inflation could take root and escalate out of control as in the inflationary period of the 1970s. Conversely, if the Fed focuses too much on inflation and raises interest rates prematurely, the economy could suffer and unemployment could rise.
Recently, the Fed has indicated that its goal for full employment is a 5 percent unemployment rate, and the goal for inflation is 2 percent. As the unemployment rate is currently 4.9 percent, it seems reasonable to assume they are satisfied with employment. However, inflation is still running at a quite low pace of 1.1 percent annually. Partially, this low inflation rate is the result of very low oil prices, and partially the result of a growing, yet sluggish economy.
In either event, I do not believe the Fed is terribly interested in raising rates until it is clear that inflation is running above 2 percent and the labor market continues to look stable. The next meeting for the Fed is December, and many observers believe that they will make a slight change by raising rates another 0.25 percent.
Q: Will rising interest rates help my investments, or hurt them?
A: Although the Federal Reserve has kept interest rates at very low levels for the past 10 years, it is a good bet that at some point as the economy continues to recover, they will begin to raise them. This process of raising interest rates could go on for several years until they are “normalized.”
A period of rising interest rates may or may not be a good thing for your investments depending on how the underlying investments use capital. In broad terms, if one is a lender, rising rates are likely beneficial since the return on the investment will be higher. However, if one is a borrower, rising rates will likely hurt profitability.
Therefore, it is thought that rising rates will be beneficial to banks and other financial institutions that are lenders. As the interest rate spread between what banks pay depositors and what they charge lenders widens, so does their profitability.
On the other hand, highly leveraged firms and companies that are dependent on utilizing debt to fund their operations could be at a disadvantage in a rising rate scenario as the higher cost to borrow could eat into their profits. Investors should pay extra attention to balance sheet debt when rates are rising.
For investors in bonds (which in effect represents being a lender), rising interest rates could equate to rising income, which is particularly attractive to retirees and other income investors. Most bonds are issued with a fixed interest rate (coupon) and a specific maturity date. As bonds mature in a rising rate environment they often can be replaced with bonds that pay a higher coupon.
In short, for most investors with diversified portfolios, rising interest rates should not be much of a concern. Shrewd investors might well find more opportunities than pitfalls.
Jonathan Lokken, CIMA is managing principal of Lokken Investment Group LLC in Lewes. To submit a question, email jlokken@lokkeninvest.com.
