First US interest rate increase in almost a decade: What does it mean?

This image shows USA, Columbia, Washington DC, Capitol Building as we discuss the recent interest rate increase by the US Fed

News & Insights

Gareth Trainor

18th December 2015 at 11:36am

The US Federal Reserve (the Fed) has raised interest rates by 0.25%. It might sound like a small thing, but it’s the first increase in almost a decade – the first move towards a more ‘normal’ environment after the extreme measures used during the financial crisis.

While it’s certainly newsworthy, there are no dramatic market movements that are causing me concern. So what does it actually mean and does it matter here in the UK?

Why were rates increased?

All members of the Fed voted for the increase to between 0.25% and 0.5%. The main reasons were:

  • an improving labour market
  • increased household spending
  • investment by business
  • a continued low rate of inflation.

Janet Yellen, Fed Chair, also explained that if they continued to delay they risked having to increase rates too quickly at some point to prevent overheating the economy and breaching inflation targets. Such abrupt action could lead to another recession.

Slow and steady

While the rate increase was a landmark move it was widely expected – markets had ‘priced it in’ to the value of shares – so no dramatic market moves.

Investors were much more focused on the future path of rate moves. Yellen explained that future action will depend on the economy, but it will be gradual.

The Fed projects that the rate will be 1.5% in late 2016 and 2.5% in late 2017 and that it will not get close to normal levels of around 3.25% until 2018 – with Yellen reassuring that “were the economy to disappoint, the Federal Funds rate would likely rise more slowly”.

Markets liked this news and shares across the world rose.

If US rate rises are modest, occurring over an extended period of time, markets should take future rises in their stride

What does it mean to the rest of the world?     

  • It reflects the Fed’s confidence that the economy will continue to strengthen. The Fed also increased its projection for economic growth slightly
  • It could mean higher borrowing costs for developing economies; higher interest rates could strengthen the dollar and this is the currency that many countries borrow in
  • In the UK, rate increases are more likely. As the US has moved first it means that the UK can increase rates without upsetting the value of the pound against the dollar.

This action has removed the uncertainty that’s been hanging over markets for some time.

As Andrew Milligan, Head of Global Strategy at Standard Life Investments, explains: “Janet Yellen indicated there were likely to be further modest rises throughout 2016. But, importantly, she noted rises were not automatic, and would strongly depend on the pace of the US economic recovery.”

And he adds that: “If US rate rises are modest, occurring over an extended period of time, markets should take future rises in their stride.”

And in the UK…

When it comes to the UK, Andrew highlights: “With the US set firmly on the path to progressively higher interest rates, the Bank of England will now almost certainly follow.” However, he explains that the Bank of England will also be cautious with both the timing and speed.

The UK recovery is fragile with low wage growth, which means that policymakers will be anxious households aren’t placed under more financial pressure. “While rate rises are modest and gradual, markets will not adversely react – they all know rates are only going one way.”

And for you…

Looking at the wider context, we should start expecting interest rate rises in the UK sooner rather than later. Looking at your own circumstances, depending on what you’re invested in, you’re unlikely to have seen any significant impact following this announcement. Given the longer-term outlook for interest rates, if you have a well-diversified portfolio already, you may not need to take any action.

However, if you’re in a single asset class or geography you may want to review why you invested in that way in the first instance – and review your investment options to ensure they’re still appropriate to meet your goals.

If you have any questions or concerns, post your comments below. We’ll continue to keep an eye on what’s happening in the markets, and update you if anything changes.

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The information in this blog or any response to comments should not be regarded as financial advice and is based on our understanding in December 2015.