“Everybody talks about the weather, but nobody does anything about it.” — Attributed to Mark Twain
You could make the same statement about U.S. interest rates these days. Interest rate policy from the Federal Reserve Bank involves plenty of financial media discussion but little or no action by the Fed. It’s fair to say that interest rates go up and down over time, but predicting when they will change, how much they will vary and how long the rates might last is nearly impossible.
The last interest rate increase occurred in June 2006 — nine years ago. Since then, rates have declined to near zero and have remained there.
Here’s a quick refresher: Interest is the cost of borrowing money. It typically is expressed as a percentage over a certain time period, usually one year. The rate is calculated by dividing the amount of interest charged by the amount of principal borrowed. If a bank charges $5 per year to borrow $100, the rate is 5 percent. The lender receives the interest as income, and the borrower pays interest expense.
The Fed has kept interest rates very low since 2008 and 2009 to boost economic growth and lower the unemployment level — the two main goals of the Fed. In theory, this helps the economy recover, keeps government borrowing costs low and allows consumers to refinance high-interest debt. It frees up cash flow for consumption. Companies issue bonds at lower interest to boost capital, while municipalities such as schools and hospitals bolster tight budgets.
Caught in the middle are beleaguered savers who have seen their incomes decline from lack of savings and interest income. J.P. Morgan reported on June 30 that an insured six-month, $100,000 Certificate of Deposit (CD) paid interest of $130 in 2014. This compares to payment of more than $5,000 for the same CD in 2006. One concludes that savers have little political clout, and we hear nothing about the decline in living standards caused by zero interest rates for those individuals living on fixed income.
The bigger risk is potential losses in bonds and bond funds if rates spike up unexpectedly in response to inflation expectations. Investors who purchased higher yield, lower quality and longer duration bonds could be adversely affected. Understanding your fixed-income investments is critical when rates rise. Many investors have relied more on capital gains and asset growth the past few years, which could improve if interest rates go up.
Bond investors and savers enjoyed very high interest rates in the late 1970s and early 1980s. The long decline in rates has created a 30-year bull market in bonds, well beyond the memory of people who have never experienced losses in bonds and bond funds. Consider placing interest-bearing money in short-duration, high-quality, liquid accounts until we see a clear direction on Fed policy. They may not pay much, but a little interest is preferable to an unexpected loss of capital in your conservative, fixed-income portfolio.