After a long period of steady growth, the Dow Jones sharply decreased in early February, jolting the business and investor communities alike. There are a few reasons for the correction and ongoing volatility, including rising wages, concerns about inflation and anticipated interest rate hikes. This last cause is a near-certainty expressed by many members of the Federal Reserve, and it's not going to impact only stock markets, but small business owners as well.
The Federal Open Market Committee (FOMC) is the Federal Reserve body responsible for governing monetary policy. Part of this means setting the federal funds target rate, which is the rate at which banks lend each other money overnight. This impacts interest rates everywhere in the larger economy, so when the fed funds rate is hiked, generally so are rates elsewhere.
Here's what small business owners need to know about rising interest rates and how to best take advantage of the current low-rate environment before it comes to a close.
What are interest rates?
It's a basic question, but when dealing with macroeconomics, it's worth reviewing the basics. At its core, what is an interest rate? Since interest rates are a percentage paid on top of the repayment of borrowed money, we can quite simply consider interest as "the cost of money." And if the fed funds rate generally impacts all other interest rates – when the fed funds rate goes up, typically so does your bank's – money becomes more expensive to borrow, making saving cash a more attractive prospect.
On the other hand, when the fed funds rate goes down, it incentivizes borrowing. Moreover, saving is far less lucrative, so individuals and businesses who had been accruing interest in a savings account might be more likely to spend some excess funds on needed investments. This is why the Federal Reserve dropped interest rates during the economic crisis in a bid to incentivize spending and stimulate the sputtering economy.
By raising and lowering interest rates, the Federal Reserve is encouraging certain behaviors it deems beneficial to the larger economy. After the financial crisis, economic activity was grinding to a halt, so to encourage borrowing and investment, the Fed dropped rates. However, leave rates too low for too long and you risk creating an inflationary environment, because high levels of spending – demand for goods and services – drive prices up. Raising the interest rate combats these effects, but raising them too quickly can stifle economic activity.
Altering interest rates, then, is like a balancing act between incentivizing economic growth on one hand, and managing inflation on the other – and the FOMC orchestrates this balancing act. Today, the Fed is determining that the economy is sufficiently recovered from the 2008 financial crisis to begin weaning the economy off of cheap money, and that ongoing prospect is in part responsible for the volatility in financial markets.
Recent history of the fed funds rate
The prospect of rate hikes is not new. In fact, the Federal Reserve has been periodically lifting rates since December 2015. However, since the financial crisis in 2008, the Federal Reserve held interest rates at unprecedented near-zero rates. That means the cost of money has been cheap for nearly a decade, and businesses and investors have gotten used to it.
"We've gone from an environment where the Fed has been especially accommodative going back to financial crisis," said Mark Wynegar, president and portfolio manager of Tributary Capital Management. "And what we see is economic data that has given the Fed room to unwind these things and normalize interest rate policy a bit. GDP is perking up a bit, and we've seen an exceptionally long economic expansion. We're starting to catch some whiffs of inflation, a bit of a bump on the wage front, and the Fed is using that as a backdrop to get rates to more of a normal level."
Although recent rate hikes have ended the seven years of near-zero rates, the 1.5 percent target rate is still incredibly low, and until now, the markets reacted with a collective yawn, continuing a gradual climb year over year since the recovery. Now, however, as rising wages and fears of inflation have surfaced, so has anxiety about further rate hikes, which the Fed has not been shy about expressing are in the works.
Loretta Mester, president and CEO of the Federal Reserve Bank of Cleveland, said she expects three or four 0.25 percent rate hikes in 2018, which would bring the uppermost target rate to 2.5 percent. Other officials have worried aloud that three hikes might be too much, but nobody seems to suggest that there will be no hikes. However, even if the target rate hits that 2.5 percent upper limit by the end of the year, that will still be historically low. For example, prior to the financial crisis, the fed funds rate sat at around 5 percent, also on the low end of the historic spectrum.
What should you do before rates increase?
The good news is that you haven't missed your window to take advantage of historically low rates. The better news is, even if four rate hikes go through in 2018, rates will remain historically low. However, finance is often a game of relativism – buy low, sell high – so you'll want to make the right moves while rates are still this low.
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