As you may have read in the media, the Federal Reserve (Fed) raised its benchmark interest rate to 1.00% in March.  This was the second increase in just three months and the most the Fed has raised the rate in over eight years.  What’s the significance of such rate hikes, particularly to investors?

Let’s start with a very brief primer on monetary policy.  I promise to try not to bore you.  Monetary policy is the approach that a country’s central bank takes to control its money supply.  The primary objective is to maintain price stability and full employment in a capitalistic economy.  In the U.S., it’s the Fed that serves this role, and their most recent policy mandates, which were set under the Obama administration, are to keep inflation under 2% annually while at the same time maintaining an unemployment rate of between 4.5% and 5.0% (which the federal government considers to be full employment).

How does the Fed control the interest rates that consumers and businesses have to pay to borrow money?  The answer is that they do not and cannot control them directly.  The Fed can only control two things:

• The reserves that banks need to hold in order to be able to lend money.
• The federal discount rate, the interest rate at which eligible financial institutions may borrow funds directly from a Federal Reserve Bank.

It’s the combination of the two that causes other interest rates to change.  Here’s how: when the Fed raises the discount rate, it becomes more expensive for banks to borrow from the Fed.  So banks borrow less, which reduces the overall supply of available money in the economy, which ultimately increases commercial short-term interest rates.  Lowering the discount rate has the opposite effect, bringing short-term interest rates down.

Note, however, that it’s only the discount rate – a very short term interest rate – that the Fed controls.  And I mean short-term.  This rate is used typically for overnight borrowing.  What other interest rates does it influence?  Mostly shorter-term borrowing rates such as the federal funds rate (the rate at which banks borrow from each other), credit card rates, home equity lines of credit, short-term bond interest rates, etc.  After the Fed made its two interest rate adjustments in December and in March, both the federal funds rate and the prime rate, for example, increased by exactly the same amount (0.25%) each time.

What about longer-term rates such as mortgages and ten-year U.S. treasury bonds?  Actually the Fed’s action had much less effect on those.  Take the 11^th District Cost of Funds (COFI), an index reflecting the weighted-average interest rate paid by banks for savings and checking accounts in the 11th Federal Home Loan Bank District covering Arizona, California and Nevada.  A common benchmark for adjustable rate mortgages in this area, the rate as of this writing was 0.59%, down from 0.67% a year ago despite the Fed’s discount rate increases.

In other words, standard Fed monetary policy actions tend to affect short-term interest rates to a much greater extent than long-term rates.  But what happens if the Fed needs to bring down long-term rates?  That’s what happened in 2008, leading to the creation of quantitative easing (QE), in which the Fed started buying up billions of dollars of mortgages that no one else wanted to buy.  That helped reduce longer term rates but added to the U.S. government’s debt burden.  More significantly, it distorted the debt market, making it harder for investors (and especially retirees) to get what should have been a higher market-rate return on lower-risk fixed income investments.

Investors are looking forward to the Fed freeing-up what has historically been artificially low interest rates.  However, the consequent rise in rates (both long-term as the Fed winds down QE and short-term as they raise the discount rate) will have a significant impact on many different asset classes.  I will discuss this in more detail next week.