The Federal Reserve has signaled a new phase in its battle against inflation, which could mean interest rates will be rising higher — and for longer — than previously expected.
That means new challenges — and opportunities — for consumers and investors who have grown accustomed to an era of super-low interest rates.
For many borrowers, it might be time to consider reducing high levels of variable-rate debt, including credit cards and home equity loans, which will only get costlier to maintain in coming months. Conservative investors, in the other hand, finally can expect to get decent levels of return from money-market accounts and bank certificates of deposit.
Under Chairman Alan Greenspan, the Fed has raised the benchmark overnight lending rate seven times since June, pushing it up to 2.75 percent from a 46-year low of 1 percent. On Tuesday, the Fed signaled it intends to continue tightening credit, warning that “pressures on inflation have picked up in recent months” and risks can be limited only with “appropriate monetary policy action.”
The Fed’s statement has intensified a debate among economists and market analysts over whether the central bank is likely to accelerate the pace of rate hikes, perhaps with a half-point increase in May or June. In any case there is widespread agreement that short-term rates are likely to be significantly higher a year from now.
Analysts typically expect an overnight rate between 3.5 and 4 percent by the end of 2005, which could boost the commercial bank prime rate up to 7 percent from the current 5.75 percent. Long-term rates are harder to forecast, but the average 30-year fixed mortgage has crept up to more than 6 percent from less than 5.6 percent in early February, when Greenspan declared that low long-term rates were a “conundrum.”
Here are some areas where rising rates and potentially higher inflation could affect your personal finances and investment decisions:
Savings and bonds
For people who depend on interest income, the past few years have been lousy, with rates on basic money market accounts falling well below 1 percent. Now rates of 2 percent are more typical, rising to 2.7 percent for accounts with $50,000 or more, according to Bankrate.com.
That may not seem terrific, but money market accounts are one of the safest investments available, and rates are likely to go higher.
“If the inflation rate jumps materially, money markets will reflect that, and without the risk of lost principal -- the risk-reward proposition is very good,” said Tony Crescenzi, chief bond market strategist at Miller Tabak & Co.
Certificates of deposit and short-term Treasury securities also are offering a much better payoff than they were a year ago. Experts generally recommend sticking to shorter-term securities that mature in three months to two years and setting up a “laddering” strategy that allows you to continually roll over your investments and take advantage of rising rates.
Treasury Inflation-Protected Securities, or TIPS, have been performing well and offer a good hedge against inflation. Like other fixed-income securities, they can be purchased directly or through specialty mutual funds.
Long-term bonds are riskier now because their value will drop if inflation continues to rise. And Crescenzi suggests that investors steer clear of high-yield “junk” bonds and emerging-market securities, which have dropped in value over the past two weeks. “One wants to trade up the credit quality scale because higher Treasury rates means the risk-reward (tradeoff) tends to worsen for these riskier assets.”
Mortgages
The latest jump in mortgage rates has put the brakes on refinancing activity but refinancings still account for about 40 percent of all mortgage activity, so there are still opportunities out there.
For homeowners who may have been sucked into short-term, adjustable-rate mortgages with low introductory rates, it might make sense to refinance to lock in a rate for at least five years and maybe 30.
“It’s not too late,” said Robert Pagliarini, executive vice president of financial planning for Allied Consulting Group, an investment management firm in Los Angeles. “Interest rates are just going to go up from here.”
But Bob Walters, chief economist at online lender Quicken Loans, warned ARM-holders not to panic. “I am of the camp that says the 30-year is not the best option for a lot of people,” he said.
For example, you could have borrowed $200,000 last year at 4.75 percent with a 5-1 adjustable-rate mortgage, meaning it would be fixed for another four years. If you refinanced now, you could guarantee a fixed rate of 6.25 percent for 30 years, but you would pay an extra $12,000 in interest over the next four years, Walters figures.
Of course if mortgage rates rise to 9 percent and you live in the house another 20 years, that will be a worthwhile tradeoff. But Walters says the hyperinflationary conditions that produced those kind of rates in the early 1980s are unlikely to recur today because of global competition.
Even with rising mortgage rates, Walters does not expect housing prices to collapse, even in the frothiest of markets on the coast. But he cautions against speculative buying of real estate.
“Diversification is important,” he said. “Most people have a large portion of their asset base in real estate, just by virtue of their primary residence.”
Stock market
The stock market tends to respond poorly to rising interest rates and inflation fears, and major indexes have drifted lower over the past several weeks to near their lowest levels of the year. Higher rates, higher oil prices and the threat of higher inflation all threaten to squeeze corporate profit margins. In addition, the double-whammy of higher oil prices and higher interest rates could translate into sharply slower economic growth in the second half of the year, although there are few signs of a slowdown yet.
Once again, experts recommend that investors stick with a long-term strategy of asset allocation, rebalancing occasionally as needed. That said, there are certain stock classes that tend to outperform others during times of rising interest rates.
Financial-service companies, home builders, real estate firms and consumer cyclicals like automakers are considered among the most vulnerable to current conditions. Consumer staples like food, cosmetics and soap should do well in any economic storm, along with office equipment makers and retaielrs. Energy-related stocks might seem like a good idea but are extremely overpriced, said Pat Dorsey, senior stock analyst at Morningstar.
Consumer debt
Carrying a high amount of credit card debt is never a good idea, but the Fed’s steady rate hikes have made plastic debt even more unpleasant.
The average variable rate on a so-called platinum credit card, the industry standard, has risen to 12.8 percent from 10.7 percent in June, said Greg McBride, a financial analyst with Bankrate.com. Home equity lines of credit have risen to about 5.9 percent from 4.7 percent.
Rates on both types of credit are likely to go higher, so the message is clear: Pay off whatever debt you can, and consolidate the rest at the lowest possible rate. As savvy traders know, it never makes sense to fight the Fed.