Interest rate movements affect your personal finances
By Gary Parsons 15 Feb 2014
As a result of the financial crisis, the Federal Reserve moved to keep interest rates at historic lows (near zero) in order to stimulate the economy. Have you often wondered what all these financial machinations mean for you?
This month’s discussion will center on how the Fed manages to achieve its objective and lay out in simple terms what it means for you.
One of the ways the central bank has achieved this goal is through a process you may have heard of known as quantitative easing, or QE. The Fed is now on round three of this program, known as QE3. While the intricacies of this program are beyond the scope of this column, the basic premise is that the Federal Reserve purchases enormous amounts of Treasury securities in order to keep rates near zero.
As demand for the bonds goes up, prices rise and yields (thus interest rates) drop. Bond prices and yields have an inverse relationship. Unwinding has the opposite effect. The Fed is now in a period of “tapering,” which is simply reducing the monthly purchases of bonds, so far in $10 billion increments, from the initial $85 billion level.
Through this program, the Fed has effectively kept interest rates very low, making money very cheap. So, this begs the question, which is better for you and your savings? The answer, as you might have imagined, is not all that straight forward.
Let’s establish that the goal of the Fed was to manage the economy out of a recession, which it has effectively done. As the economy gets back on its feet, people are saving more and retirement plans are stabilizing. Now, depending on your position, you are either rooting for higher interest rates or sustained low interest rates. The macroeconomic effects aside, which group are you in?
People approaching retirement are looking for safe returns. These safe returns generally come in the form of fixed income securities whose value and earnings are derived from the interest rate market. Remember the days when a safe bond paid upwards of 5-7 percent? The older savings generation longs for those safe returns and thus would enjoy a higher interest rate environment leading up to and during their retirement years.
Keep in mind, as interest rates increase the bonds you are currently holding will lose value.
Alternatively, if you are a recent college graduate or a young family purchasing cars and houses and have a retirement fully invested in equities, you rather enjoy the low interest rate environment. You are borrowing at historical lows and every percent that interest rates increase, your life gets more expensive. Additionally, the low yields on bonds have driven a lot of investment into the stock market, which has seen record gains.
You are benefiting all around from the low interest rate environment and likely aren’t concerned with the troubles of the near-retirement crowd; that is, unless you’re now going to have to house your parents, who lost all their money in the market, but that is a different story entirely.
The point is, as you hear people championing or decrying the Fed’s tapering moves, your personal feelings will depend on what you need interest rates to do, the classic “what’s in it for me.” This is, of course, without giving consideration to the larger economic effects of interest rates but rather focused on how your behavior and financial position are effecting by the market’s prevailing interest rates.
Gary Parsons is a is a certified financial planner who writes his column each month for the Democrat. Advisory Services offered through Investment Advisors, A division of ProEquities, Inc., a Registered Investment Advisor. Securities offered through ProEquities, Inc., a registered Broker Dealer, Member, FINRA & SIPC.