Once again, The Fed spoke and the markets moved. If you are wondering why the stock
market reacts so strongly to even an indication that interest rates might change in the
future,
you are not alone. Here are answers to help you understand.
What did the Fed do today?
The Fed announced a shifting of its "bias" toward increasing rates. The Fed did
not actually change
interest rates.
What does that bias mean?
It means the Fed is considering raising rates in the future, although it is not committed
to doing so.
Could the Fed raise rates even if it hasn't announced a bias?
Yes, although it would be less likely to.
What is the Fed and what does it do?
The Fed is the Federal Reserve Board of Governors, chaired by Alan Greenspan. It controls
the
monetary policy of the U.S. Government.
Why would they consider raising interest rates?
The Fed is worried about the potential of inflation increasing. Raising interest rates
makes it less
likely that inflation will increase.
How do higher interest rates help lower inflation?
If interest rates are higher, businesses are less likely to borrow money to expand
production. The
more economic production there is, the more demand there is for workers and other
resources
(such as oil, land, and raw materials), which increases wages and resource prices. So
raising interest
rates reduces demand for these resources and helps hold down price increases.
Moreover, higher rates encourage consumers to save instead of buy, which also reduces
demand.
So increasing interest rates is a good thing, right?
Not entirely. Higher rates lead to less production, which means fewer jobs and lower sales
growth
for companies. The Fed tries to balance low inflation with the need for employment
potential and
economic growth.
Currently, unemployment is at its lowest level in two decades and economic growth is
relatively
high, so the Fed is more concerned about inflation.
How do higher interest rates affect investors?
Not well. Bond prices fall because the higher interest rates make existing bonds less
attractive than
new ones. Stocks typically fall because of the potential for lower growth and lower
profitability that
comes with higher interest rates.
If raising rates hurts stock prices, why would the Fed do it?
The Fed's goal is not to make stock prices as high as possible. Its goal is to balance the
aims of low
inflation, low unemployment, and stable economic growth.
Should I be concerned if they raise rates in the future?
No. Although stock prices are likely to fall, perhaps by as much as 2% if the Fed raises
rates, it will
be only a short-term effect. The stability of low inflation and economic growth has
contributed
greatly to the increase in stock values over the past 20 years.
 Lummer's
Logic Archives
Scott L. Lummer, Ph.D., CFA, 401k Forum's Chief Investment
Officer, is a recognized expert in the investment field. He has conducted extensive
research on asset allocation, international investing, risk management, mutual fund
analysis, ethics and valuation, and is a co-author of The Pension Investment Handbook. He
wants to know what's on your mind, so feel free to send him your questions about the stock
market! He'll answer as many as he can in his weekly column.
|
