The Federal Reserve Open Market Committee, or FOMC, decided to raise interest rates at the conclusion of its December meeting, as it was widely expected to do. This represents the third interest rate hike of 2017 and the fifth of the current rate-hike cycle that began in 2015.
However, it appears that the Fed is just getting started. The latest projections show that the Fed expects another seven rate hikes over the next three years, which would more than double the current federal funds rate.
Seven more rate hikes?
Unless there's a major surprise in the Fed's announcement, the most important thing to keep track of isn't the current federal funds rate. Rather, it's the expectations for future interest rate activity, which are made public along with the Fed's latest statement.
As of December, here's what the median expectations of the FOMC are calling for:
- Three rate hikes in 2018, with a year-end federal funds rate target range of 2.00%-2.25%.
- Two more rate hikes in 2019, with a year-end federal funds rate target range of 2.50%-2.75%.
- Another two rate hikes in 2020, with a year-end federal funds rate target range of 3.00%-3.25%.
In a nutshell, the FOMC is expecting to increase interest rates by 175 basis points (1.75%) over the next three years.
To be clear, I use the term "rate hike" to mean a 25-basis-point increase, although larger rate hikes are certainly possible. For example, the Fed could choose to hike rates twice in 2018, once by 50 basis points and again by 25, with the same year-end effect.
What a 175-basis-point increase in the federal funds rate could mean for you
Rising interest rates affect savings accounts, investments, and a variety of consumer loan rates, but all of these are affected in different ways. Here's a quick rundown of what to expect:
- Savings accounts: To be clear, savings account interest rates are not directly linked to the federal funds rate. However, they do tend to increase as the Fed raises rates, just to a lesser extent. For example, a 25-basis-point increase in rates might result in a 15-basis-point rate increase in savings account interest rates, although consumers have not yet benefited much from the current rate-hike cycle.
- Credit cards: Unlike savings accounts, credit card interest rates are directly linked to the federal funds rate. Specifically, your credit cards' interest rates are based on the prime rate, which in turn is based on the federal funds rate. So, you can expect your credit card interest rates to rise in line with the Fed's rate hikes.
- Auto loans: While auto loan interest rates aren't directly linked to the federal funds rate, they tend to move in the same direction and by roughly the same amount. In other words, if the Fed does raise rates by 1.75% over the next three years, you can reasonably expect the average auto loan interest rate to rise by approximately the same amount.
- Mortgages: As a general rule, the longer-term a loan product is, the less it tends to correlate with short-term benchmark interest rates like the federal funds rate. So, while the Fed's rate hikes certainly put upward pressure on mortgage rates, it's impossible to predict their effect. In fact, the average 30-year mortgage rate in the U.S. is exactly where it was before the first rate hike in 2015, despite a 125-basis-point rise in the federal funds rate since then.
- Home equity lines: Home equity lines of credit (HELOC) are based on the U.S. prime rate, just like credit cards, and therefore will increase (or decrease) in line with the Fed's rate movements.
- Investments: Rising interest rates certainly put pressure on the stock market -- dividend-paying stocks in particular. However, the expectations are the most important thing, and it's fair to say that the current expectations are at least somewhat priced in. In short, if the Fed's forecast changes, that's what could really move stocks.
We're just getting back to normal
As a final thought, keep in mind that the past decade or so has been a historically unprecedented period of low interest rates and that a federal funds rate in the 3% range is quite normal in a historical context, if not a bit on the lower end.
So, while things like 7% mortgage rates, 3% savings account interest rates, and 20% average credit card interest rates -- all of which are possible if the Fed's three-year projections come to fruition -- may sound quite high, they're really not. This rate-hike cycle is more of a normalization than anything else, and it's entirely possible that the Fed could end up raising rates even higher than these projections if the economy keeps heating up.
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