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Will a rising federal funds rate hurt the economy?

December 11, 2013

| MoneyRates.com Senior Financial Analyst, CFA

Amid all the speculation about when the Federal Reserve will begin tapering back from its stimulative, low-interest-rate measures is a persistent subtext: the question of whether the economy has become overly dependent on unnaturally low interest rates.

Certainly, the stock market has acted jittery whenever the Fed signals that it may soon raise rates. However, since raising rates is predicated on the economy showing signs of strength, should people really be so fearful of higher rates?

To get an historical perspective on this question, MoneyRates.com looked at economic growth and stock market performance during periods when the federal funds rate was rising or falling. The numbers suggest that the economy need not fear rising rates, but that stock market investors perhaps should.

Rising interest rates and the economy

Over the past 50 years, real GDP growth has averaged 3.11 percent a year. That growth rate has been stronger in times of a rising federal funds rate than in times when the rate has fallen.

In calendar years when the federal funds rate has increased, real GDP growth has averaged 4.08 percent. In years when that rate has decreased, real GDP growth has averaged just 2.14 percent. The severity of the decrease also seems linked to the strength of the economy. When the federal funds rate has dropped by 1 percent or more, real GDP growth has averaged just 1.45 percent, and when that rate dropped by 2 percent or more, growth has been lower still, at 0.19 percent.

This underscores the reality that the Fed is likelier to raise rates when the economy is strong, so clearly rising rates is more a symptom of good economic health than it is an obstacle for the economy.

Rising interest rates and the stock market

While the economy has thrived when rates were rising, the stock market has not. Stocks have gained an average of 7.80 percent over the last 50 years, but this number drops to 2.36 percent when the federal funds rate has risen by 1 percent or more, and to just 1.70 percent when that rate has risen by 2 percent or more.

What stocks really like is a stable interest rate environment. In years when the federal funds rate has changed by less than 0.5 percent up or down, stocks have gained an average of 17.67 percent. So, the key to the stock market's fate next year may not depend on whether the Fed raises rates, but on how sharply it raises them.

Interest rates and retirement income

Though stocks may struggle in a rising-rate environment, the retirement saving implications will be offset to some degree by the greater income production that comes with higher savings account rates, bond yields and CD rates. If you can get more income from your savings, you may be able to get by with less growth on your investments.

To a large extent, lowering interest rates to stimulate the economy is based on encouraging borrowing. Unfortunately, it may be that the Fed has also borrowed against the stock market's future returns in order to inflate its recent performance. Investors should take note: What they've earned during this period of very low interest rates may have to sustain them through some lean times as interest rates rise.

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