The Federal Reserve’s recent announcement that it will maintain the federal funds rate in a range between 0.00% and 0.25% through December 2014 has generated the usual analysis about whether Chairman Bernanke and his colleagues are doing the right thing. But the Federal Reserve’s policy may be less about right versus wrong than about the trade-offs for investors and consumers.
When the Federal Reserve makes a determination about movements in interest rates, it bases its decision on prospects for economic growth and whether existing growth can be sustained. The Federal Reserve considers the outlook for inflation, the federal budget, consumer finances, corporate earnings, and a variety of other factors. Maintaining interest rates at a historically low level, which has been the Federal Reserve’s policy since December 2008, is a tool for stimulating economic growth.
A Domino Effect
The fallout from the Federal Reserve’s actions can be significant. The federal funds rate influences the prime rate, which in turn has a bearing on rates that lenders charge for consumer and corporate borrowing. When the prime rate is relatively low, lenders may offer lower rates for mortgages, credit cards, and other forms of credit than they otherwise would. It is important to remember that consumer demand and a household’s creditworthiness are also significant factors in interest rates assessed by lenders.
There are other plusses associated with low short-term rates. Borrowing costs are relatively low for corporations, which can impact earnings and escalate stock market returns.1 In addition, with banks offering marginal returns on savings products, Haisman Wealth Management, Inc. and our portfolio managers have minimized equity positions in your account(s) rather than using additional growth investments with the goal of earning higher returns.
A Flip Side
Just as low short-term interest rates bring certain benefits, there
may be drawbacks for the income portion of your account(s) and also for the broader economy. When short-term rates eventually go up, the situation is likely to be a negative for bonds in your account(s) because of the inverse relation between interest rates and bond prices.2 Historically, rising interest rates have caused the prices of existing bonds to decline because newly issued bonds carry higher rates, which push down the value of previously issued securities.
Haisman Wealth Management, Inc. and our outside managers have been fortunate to obtain annualized returns between 4-5% on the income portion of your account(s) despite the low interest rates.
We remain very vigilant for higher interest rates that would affect your bond holdings. We are prepared to use alternate investments whose objective is to maintain your income and principal during a rising interest rate period.
In addition, we have available income investments that are not based on interest rates that can also be used to generate income in your portfolio.
Economic policy frequently presents both plusses and minuses, and low short-term interest rates are no exception. So far we’ve been able to mitigate the minuses.
1Investing in stocks involves risks, including loss of principal.
2Bonds are subject to market and interest rate risk if sold prior to maturity. Bonds are subject to availability and change in price.