The Federal Reserve (Fed) is the central bank of the U.S. It's responsible for managing monetary policy, regulating the banking industry, and maintaining the financial system's stability. That's why, when the U.S. started seeing high inflation in 2022, the Fed stepped in to try to help by raising interest rates. It's now raised interest rates 10 times since March 2022.
The federal funds rate is the rate banks and other financial institutions pay to borrow money from each other. It's also one of the benchmark interest rates that affects things like mortgages, car loans, and credit card debt.
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When inflation is too high, the Fed raises interest rates to make borrowing more expensive (and therefore less appealing) and spending less attractive. Ideally, it slows down the amount of money in circulation, raising the dollar's value and bringing down prices.
So what does that mean for your stocks? Here are some potential effects of rising interest rates.
Specific industries feel the effects differently
Interest rates don't necessarily have a direct effect on stock prices, but they have a ripple effect based on the implications for different sectors and companies.
Take the financial sector, for example. Banks make money by loaning it out and charging interest. This can be via mortgages, car loans, personal loans, or business loans. When the Fed raises interest rates, banks typically follow and raise their own rates. Higher interest rates mean they can make more from their loans.
The opposite is true for sectors like utilities that operate with a lot of debt. Higher interest rates make the debt more expensive and can cut into a company's profits. For a company like AT&T (T -0.44%) with over $130 billion in total debt, for example, seemingly slight percentage changes in interest can add up to a lot over time.
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Investors' reactions to interest rate changes influence stock prices
Again, the Federal Reserve's interest rate change won't directly affect stock prices, but investors' reactions to the change will.
For example, if investors believe a rate hike will lead to inflation control and a more stable economy, they may become more bullish and ramp up investing. This money increase in the stock market generally translates to rising stock prices.
Conversely, higher interest rates may lead investors away from stocks and toward fixed-income investments like bonds that have higher yields with higher interest rates. U.S. Treasury bonds -- which are as close to a risk-free investment as there is -- currently have yields of around 4% to 5% for three-month to two-year terms. Many investors would rather take the guaranteed returns instead of banking on stock prices.
Interest rates are one piece of the puzzle
As tempting as it may seem, you shouldn't base your investing decisions solely on the Fed's interest rate changes. The key to successful long-term investing is consistency and time invested.
The Fed has changed interest rates 27 times since the 2008 Great Recession. You don't want to find yourself in a situation where you're making short-sighted decisions based on interest rate changes that could go against your best long-term interest or goals.
Loading up on bank stocks because interest rates are increasing could throw your portfolio's allocation off. Selling utility stocks because their debt is becoming more expensive could cause you to miss out on dividends. And refraining from investing until the Fed announces it's done with interest rate changes could cause you to miss out on future growth.
Interest rate changes are just one piece of the puzzle. The goal should be to have a well-diversified portfolio that doesn't rely heavily on any one factor. Instead, you want a portfolio that can carry you for the long run, regardless of the inevitable interest rate changes along the way.
Consistency and the ability to ignore short-term noise and focus on the long term separate many investors. Keep your eyes on the prize.
