Thursday April 23
Posted 2 p.m. Eastern
The Federal Open Market Committee meets next week, April 28-29. What, if anything, do they have up their sleeve this time around? I have no idea. The announcement at the last meeting of $300 billion in Treasury purchases and stepped-up purchases of mortgage-backed securities to the tune of $1.25 trillion and $200 billion in GSE debt was a pleasant surprise that bore immediate fruit by pushing mortgage rates even lower. The surprise factor seemed a key part of the plan so we shouldn't expect a tipping of the hand for anything that might come about at this or future meetings.
But it is time to start planning for something we do know will happen eventually, and that is an increase in interest rates from today's record-low levels. Yes, I know it might be a good long while before it happens. The Bank of Canada said this week they would maintain their benchmark rate of 0.25 percent for 14 months. I'm not sure the Fed can go so far as to say that, but suffice it to say, rates will remain low for the foreseeable future.
Which makes it an opportune time to start strategizing about how to maximize the benefit of low interest rates or position yourself for the inevitable rebound to higher rates. We've seen this movie before, folks. Rates will go up, and perhaps mightily. We just don't know when.
The question is already coming up. On April 20, Fed Vice Chairman Donald Kohn said this in response to a question about the Fed facing pressure not to raise interest rates when the time comes: "I am sure that when we get ready to raise interest rates there will be a lot of criticism. There always has been."
From a borrower's standpoint, it pays to make hay while the sun shines. Lock in fixed rates, particularly on mortgage debt. This is prudent even if your adjustable-rate reset is a couple years off. The fixed-rate loan represents permanent payment affordability, and there are no guarantees about where fixed rates will be in a few years when a reset on that adjustable-rate loan may make it unsustainable. My fear is that homeowners with adjustable-rate loans that are seeing their rates decrease this year will be lulled to sleep and pass up the refinancing opportunity because of an unwillingness to forfeit the current low rate. Yes, refinancing from an ARM to a fixed-rate loan may entail trading away a rate at 3.75 percent for one at 5 percent. But you have the certainty of knowing the rate and payment will never change again. Disciplined homeowners may get away with rolling the dice, but that's not who this advice is intended for. After all, the disciplined folks didn't get us into this mess.
Other steps for borrowers to take include paying off high-cost debt such as credit cards and personal loans, and having a strategy for variable rate debt. What do I mean by that? Let me use a home equity line of credit as an example. A homeowner may be carrying a HELOC balance at 3.25 percent, or something in that neighborhood. At that low rate, and even less on an after-tax basis, there isn't much of a hurry to accelerate repayment. Or is there? Depending on the balance and your timetable for paying it off, consider paying it off now when HELOC rates are below 5 percent rather than trying to drag a safe through sand by focusing on repayment only after a spike in interest rates. As interest rates rise, so too will the minimum payment requirement on the HELOC. Prudent borrowers will be looking around corners and anticipating whether such an increase might strain their cash flow. If so, there is a great incentive for paying it off, or at least paying it down while interest rates are low.
What about savers? Investing in short-term CDs positions you to reinvest at higher returns once interest rates (and inflation) perk up. The current returns of 2 percent or so on maturities of one year and less don't look impressive, but they are currently ahead of the rate of inflation. As a saver, you want to make sure to always stay on that side of the ledger, and keeping maturities short will enable you to do so. Unless you're a retiree with a laddered CD or bond portfolio, it pays to stay away from longer maturities at this point because you end up locked into a return that could easily be swamped by inflation. Investing in a 5-year CD today, would earn approximately 3.5 percent APY. But if inflation picks up to 3.5 percent in two years, your entire return will be devoured by inflation ... and you'll still have three years to maturity!
From an investing standpoint, don't let the market meltdown of the last year scare you out of riskier assets. Make sure your portfolio is properly diversified -- and if it isn't, its best to do so now when you can add positions at depressed valuations. Your portfolio must be positioned to withstand an environment of higher inflation. I don't subscribe to the hyper-inflation theory or the double-digit inflation scenarios, but we'll certainly see inflation at a higher rate than zero, where it currently resides. In all frankness, I do see inflation of 4 percent to 5 percent annually on the back end of this global recession (hopefully not before). But even at 4 percent, inflation cuts your buying power in half every 18 years. At 5 percent, purchasing power is halved every 14 years.
Inflation may not just be a result, according to a New York Times opinion piece by Harvard economics professor N. Gregory Mankiw, it may be part of the solution. Here are two excerpts.
"If all of this seems too outlandish, there is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates — interest rates measured in purchasing power — could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend."
"But in the current environment, the goal could be to produce enough inflation to ensure that the real interest rate is sufficiently negative."
Even if an interest rate hike is a long way off, both borrowers and savers need to be positioned for the eventuality of higher interest rates.