Fed Rate Hikes and What They Mean for Your Retirement Money
The Federal Reserve has raised interest rates in its last 10 consecutive meetings. The majority of people who track economic and financial data have been anticipating these moves, given the expanding economy and rising inflation.
But what does a rate hike mean? And, to go a step further, what does it mean for you specifically as it relates to your retirement savings?
What Is the Federal Reserve, and What Is Rate Hike?
The Fed
The Federal Reserve, or “Fed” as it is often called, is the central banking system of the United States. Its purpose is to regulate the money supply with two primary goals in mind:
- Keep prices stable (in other words, control inflation).
- Maintain full employment.
These two goals can be at odds with each other.
When unemployment is high, the Fed will attempt to stimulate the economy by increasing the money supply, which raises the overall demand for goods and services. When that happens more labor is needed to produce those goods and provide the services. More jobs become available and the unemployment rate falls.
When inflation is the problem, the Fed will reduce the money supply to slow things down and prevent price increases from getting worse.
Rate Hike
To control the money supply, the Fed establishes a target for the federal funds rate. This is the interest rate that banks charge each other for short-term loans. The higher this rate is, the more expensive it is for a bank to borrow money. Banks will pass that cost on to their customers in the form of higher interest rates on the loans they make to them. It creates a ripple effect that raises the general level of interest rates throughout the economy.
The end result is that businesses and consumers won’t borrow as much, and economic activity will slow down.
When the Fed announces a rate hike, they are saying they have increased their federal funds rate target.
How Often Does It Happen?
The Federal Reserve has eight regular meetings per year where they will discuss the state of the economy and decide to increase or decrease the federal funds rate, or simply leave it where it is. This is based on their collective assessment and ultimately decided through a vote.
The Fed has raised the rates several times in 2023. It has not said yet if rates will continue to be raised in 2023, but it has said no rate reductions will be seen until at least 2024.
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What Does a Rate Hike Mean for Your Retirement?
Now that we’ve addressed what a rate hike is, let’s talk about how it might affect you with regard to your retirement savings.
What Does a Rate Hike Mean for Your 401(k)? Anything?
The way a rate hike affects your 401(k) depends on how you are invested. First, consider how it might impact stocks.
Two ways to consider how stocks might be impacted involve company profits and appeal relative to bonds.
- Rising rates can and often do lower company profits. Since the whole point of a rate hike is to reduce the money supply and slow economic activity to keep prices from rising further, this makes sense. Lower profits should then translate into lower stock prices.
- Rising rates also mean that investing in new debt securities becomes more attractive. These new debt instruments will pay higher rates than they did before, so some investors may decide to sell their stocks to buy them. This puts downward pressure on stock prices and lowers returns.
So, rising rates can be bad for stock prices, generally speaking. But there’s a lot more to stock returns than interest rates, and not all stocks react the same way.
Remember that rate hikes are implemented when things are going too well, so stocks can still have a lot of support too.
While rising rates may put some downward pressure on stock prices, you would be drawing too hard of a conclusion to say that returns will absolutely lag simply because of a rate hike. Market returns can often remain positive after rates increase.
How Does It Affect Your CDs?
Bank Certificates of Deposit (CDs) generally pay a fixed interest rate until maturity, so when rates rise, your rate will remain the same. However, the rate on newly issued CDs will be higher. That’s good news for you if you have CDs that will be maturing soon. You’ll be able to reinvest your money at a better rate.
The downside here is that if you have a longer-term CD, say one that doesn’t mature for another five years, you’ll miss out.
Savings and Money Markets
Because rates are so low, you get basically nothing on these types of accounts now, but higher interest rates are good for savers. You’ll get a boost on the money you earn on your savings and money market accounts when rates rise. Don’t count on it to shoot up dramatically, though. Fed rate hikes are usually very small and gradual.
Bonds
Bond prices react negatively to rising rates. That’s because when rates rise, the interest rate on newly issued bonds will be higher (just like with CDs).
Since bonds trade on competitive markets, the market price of existing bonds will drop because the interest payments the owner would receive are lower than they would get on a new comparable bond.
This doesn’t necessarily mean that you lose money.
Bonds are debt contracts with fixed interest payments and a known value at maturity. If you hold the bond to maturity then it doesn’t really matter what the market price is. You’ll still be entitled to the full maturity value.
Annuities
There are many types of annuities, but take a look at two common types that retirees might hold.
- Multi-Year Guaranteed Annuities (MYGA): These will respond to interest rate movements very similarly to CDs. Current MYGAs are unaffected, but the rate on new MYGA contracts will reflect the availability of higher rates.
- Immediate Income Annuities: These are straightforward. You pay a lump sum of money to an insurance company, and in exchange, you receive a payment for life. The payment can be fixed or variable. If you choose a variable payout option, and your payout is dependent on interest rates, then you may see your monthly payment rise, too. Your payout will not change if it is fixed.
Borrowing Money
If you plan to borrow money in retirement, a rate hike is bad news. Maybe you are considering buying a new car or downsizing your home. Those are common retirement moves, and either of these options is typically accomplished by borrowing money.
Car
You can expect to pay a higher interest rate on a car note. Fortunately, you may not have to borrow to buy a car. If you have adequate savings you could consider paying cash and avoid a loan altogether. Or, make a larger down payment to reduce the size of your loan.
Home
If you have a fixed-rate mortgage then you don’t need to worry about an existing home loan. Your rate won’t change. However, if you are thinking about moving to be closer to your kids, live in a more appealing area, or simply downsize, then you need to think about your new mortgage.
The connection between mortgage rates and the fed funds rate is less direct, but you could still see mortgage rates go up as well.
One way to avoid paying a higher rate on a home loan is to be more careful about the amount you spend. Look at homes that you may be able to purchase outright with the cash you receive from closing on your current home.
If you find the right home quickly enough, go ahead and lock in your mortgage rate before they have a chance to rise anymore.
Bottom Line
The Federal Reserve controls the nation’s money supply to promote price stability and employment.
Because inflation is the primary economic concern at the moment, the Fed recently announced that it plans to raise the fed funds target rate and will likely do so for the remainder of this year and into next.
The fed funds rate is a key interest rate that influences the economy, investments, and financial markets.
Understanding how a rate hike will impact your retirement savings requires you to think about the specific types of investments you hold because they don’t all respond in the same way.
If you plan to borrow money, you may want to consider ways that you can reduce the amount you borrow because you may be paying more for your loan.
