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Notes on an Interest Rate Rise

On December 16, the Fed raised the federal funds rate by 25 basis points. If you aren’t totally clear on what this means for investors, let’s review (if you are already clear on this, skip to the next article [1] where we discuss some of our favorite stocks for a rising rate environment).

The rate that the Federal Reserve (the Fed) controls is called the Federal Funds Rate [2], which is essentially the interest rate at which banks can borrow from each other. Any increase in this rate gets passed along to consumers and businesses that borrow from banks. So while the Fed doesn’t directly increase the rate at which it costs to, say, get a small business loan, it does push the first domino in the chain.

Why raise rates? To counteract inflation in a fast growing economy. Essentially the Fed raises rates to prevent the economy from overheating, because even though a sluggish economy is bad, excessive economic activity can actually be equally bad. Ideally, inflation occurs roughly in step with the rate of economic growth. As you probably know, since the Great Recession, the Fed has kept interest rates at about the lowest-possible lows, between a quarter of a percent and zero, but our economy has since stabilized. Inflation hasn’t yet been a problem (largely due to exceedingly low oil prices), but it is a concern, because super-low rates in a healthy economy could promote more lending/borrowing activity than is supported by the growth of our actual collective wealth (gross domestic product), which leads to the currency losing value. This is why the Fed has been eyeballing a rate increase for many months now.

A recent article [3] in the New York Times likens an interest rate increase to “a doctor’s decision that a patient is well enough to be gradually taken off medication.” It’s difficult to predict exactly how the patient (our economy) will fare in the short-term during this process, because interest rates affect a broad array of economic activities that interact dynamically with each other. The last time rates this low were raised was in 1941, which was a very different context from the present one, so it doesn’t provide the most useful precedent. Nonetheless, there are certain results that we can reasonably anticipate, even if we can’t know how pronounced they will be or what the total combined effect will be:

The degree of these effects will depend on the Fed’s pacing (we have only just experienced the first increase in a series of gradual steps) and the actual resilience of various industries, plus a bunch of X factors like oil prices, weather, and international politics.

Takeaways for Investors

As you can see, one simple rate change can have wide-ranging results. For anyone who invests in equities, there are a few takeaways:

Most of that sounds like bad news for investors, but don’t forget that the Fed is raising rates because it feels the economy is on a strong-enough upward trend that includes decreasing unemployment, increasing discretionary spending, and more housing starts. So you could end up with different stock picks based on whether you emphasize the ”economy is improving“ element or on the ”rising rates will hurt“ element.

For us at Stock Rover, we know that, as in any economic environment, we want to invest in quality companies. Given the context of the rising rate and healing economy, here is what we at Stock Rover are looking for in stocks right now:

We’ve picked 11 stocks we like right now that meet this criteria. Jump to the next post to see them! [1]