The Fed signaled plans to raise interest rates in 2022 to combat inflation, but what effect will rate increases have on your investments?
The rationale behind adjusting interest rates has to do with the Fed’s mandate to promote maximum employment and price stability. When growth is low and unemployment high, the Fed can stimulate the economy by lowering interest rates, making money cheaper to borrow, which spurs hiring and consumer spending. And when the economy is growing, the risk can be too much inflation. That’s when the Fed attempts to slow the economy by raising rates by making it more expensive to borrow money.
Interest rates and bonds have an inverse relationship such that when rates rise, bond prices fall and vice versa. But changes in interest rates do not have as direct effect on stock prices. Increases can affect stock prices, but not always and often indirectly. For instance, increased rates mean banks raise rates for business loans which can make companies think twice about hiring additional people or borrowing money to expand their business. Less consumer and business spending can lower a company’s stock value.
At the same time, rising interest rates typically happen during periods of economic expansion, so increased rates often overlap with a bull market. And some sectors stand to benefit more when rates rise, like banks, brokerages, mortgage companies, and insurance companies, since they can charge more for lending, which boosts earnings. Other sectors like technology can suffer because higher interest rates mean future profits are worth less today. Couple that with rising inflation and the present value of the future earnings is worth less. That can drive down stock prices.
Interest rate fluctuations can affect investments in different ways, so there is no single action investors should take when they change. Stay focused on your financial goals, stick to your plan, and work with your financial professional to construct a diversified portfolio that can weather short-term effects of rate changes.