What Happens When the Fed Raises Interest Rates?

When the U.S. Federal Reserve (Fed) raises or lowers interest rates, as it did in December for the first time since 2006, it sets in motion a chain reaction, and that reaction can affect you.

By raising and lowering interest rates, the Fed is trying to maintain a healthy economy. Lowering interest rates can stimulate a slowing economy, while raising them can rein in an economy that’s overheating.

The rate the Fed adjusts is the federal funds rate, which is the interest rate banks charge each other on overnight loans. But adjusting that rate has a domino effect. When the Fed changes the federal funds rate, most banks follow by changing their prime rates – the interest rates they charge their best customers.

That can affect rates for consumer loans, and therefore impact consumer spending in a big way. To illustrate: if interest rates on home mortgages increased from 2% to 10%, would you be as likely to take out a mortgage or buy a car?

A change in interest rates can also cause confusion in the financial markets, as investors try to determine how the change will affect the economy.

When the Fed raised interest rates last December, the move had been so well advertised in advance that the market reaction was muted. Stocks, in fact, performed well the day of the announcement.

The takeaway: interest rates do matter when it comes to the market and your investments, but so do other factors, such as the price of oil, the upcoming presidential election, and global events.

How Presidential Elections Affect the Markets

It’s an election year in the United States, and the 2016 presidential race has already offered up a number of surprises.

But the important question is, what might it mean for the markets, and as a result, your investment portfolio?

Looking to history, there appears to be evidence that the markets respond better to election processes whose outcomes are predictable, and, of course, that’s not the case in 2016.

First, the current president isn’t running for reelection, and departing presidents can create a void that financial markets find worrisome.

Having crunched the numbers, Merrill Lynch Global Research found that the S&P 500 Index declines by an average of 2.8% in presidential election years in which a sitting president is not seeking reelection.

Compare that to years in which the sitting president is seeking reelection: according to Merrill Lynch, the S&P 500 Index averages returns of 12.6% in those years, compared to the average annual return in nonelection years of 7.5%.

Second, in 2016, additional uncertainty in the form of intense geopolitical worries and a historically wide primary race must be factored in.

The inevitable conclusion: markets could be in for a bumpy ride all the way through to the November 2016 election. But there’s light at the end of the tunnel in the form of a so-called relief rally. According to Merrill Lynch, the first year of a new presidential term sees the markets rise by an average of 6%.

It’s also important to remember that statistics based on previous elections can’t predict with certainty what will happen in 2016, so for investors, the best way to prepare for possible market volatility in 2016 is to take a long-term perspective: work with your advisor to develop a portfolio that is focused on your individual financial goal(s).

While there may be market ups and downs this year, staying the course is almost always your best option.