 Why
this Fed meeting matters
| Will
they or won't they? In the wake of Hurricane Katrina, conjecture surrounds the
Fed's possible moves now and through the end of the year. Katrina may alter the
Fed's strategy and, if so, this will alter consumer strategies, too. Here's a
look at the impact on borrowers and investors if the Fed changes course.
With interest rates rising consistently
since June 2004, variable-rate debt has become an increasing burden as interest
charges and monthly payments ratchet higher. Most affected have been consumers
with home equity lines of credit or credit card or adjustable-rate mortgage debt.
On home equity lines of credit,
or HELOCs, rates have been rising and closing fast on the fixed-rate home equity
loans. The current average HELOC rate is 6.74 percent, compared to 7.2 percent
for a fixed-rate home equity loan. That gap of 0.46 percentage points has steadily
shrunk from more than 2.5 percentage points before the Fed began raising interest
rates and would close entirely with two more quarter-point Fed rate hikes. The
idea of locking in a fixed rate is especially attractive if the Fed stays on course
to continue boosting rates this year and beyond. But
the variable rate may not be such a risk if the
Fed raises rates at a slower pace. Also, that variable rate may be your friend
if the Fed ends up having to cut rates in 2006, as some project. If the economic
impact is strong enough to keep the Fed on the sidelines, and concerns about a
recession grow, then the variable-rate HELOC will be something to hold onto. Now
is a better time to sit tight and defer any decisions about refinancing out of
a HELOC until more economic and Fed data become available. Just be prepared for
another quarter-point interest rate hike, or two, in the interim. For
new borrowings, the decision about whether to choose a HELOC or home equity loan
still revolves largely around the borrower's need for cash. One lump sum with
a long repayment period still argues for a fixed-rate loan, whereas the ability
to access money in stages is best-suited to a HELOC regardless of the interest-rate
environment. Any prospects for a pause in interest-rate increases
serves to soften the blow on borrowers with adjustable-rate and interest-only
mortgages that are closely tied to short-term interest rates. Unlike HELOC borrowers
who would see rates decline if the Fed starts to reverse course in 2006, the impact
on adjustable-rate mortgages does not affect all borrowers the same and depends
on the specifics of when the loan was taken, the initial rate and the repricing
schedule. To ARM borrowers, a slower pace of rate hikes or even rate cuts in 2006
may still mean a payment increase next year, just not as large as otherwise. A
different path by the Fed also has an effect on interest-bearing investments.
For now, the Fed is still expected to boost interest rates, though maybe at a
slower pace. This means that yields on money markets and short-term CDs should
continue to improve and remain an attractive option for investors' dollars. But
yields on longer-maturity CDs are even less appealing than before Katrina struck.
The average five-year CD yield dipped, from 3.82 percent to 3.79 percent, last
week; and the five-year Treasury yield has slumped more than 0.2 percentage points
since mid-August, due to economic concerns. The expected impact to economic growth
during the third and fourth quarters of the year will limit the improvement on
CD yields with maturities of longer than one year. The uncertain
economic environment represents a double hit for those living on a fixed income.
Rising oil and energy prices confront retirees with higher expenses, while the
prospects for less action by the Fed ultimately hurts interest income. How
is that budget squeeze accounted for? One Bankrate.com reader living on a fixed
income answered by saying higher gas prices "kept me away from being a cable-TV
subscriber, magazine subscriber, eating out at fast food restaurants, going to
a Dodger baseball game and traveling to Las Vegas over a holiday." It
is that cutback in discretionary spending that represents the economic risk the
Fed must gauge. A larger-than-expected reduction in economic performance could
lead the Fed to begin cutting interest rates in 2006. One very influential voice
of the investment world, Bill Gross, managing director of Pacific Investment Management
Company, or PIMCO, foresees "an eventual Fed easing at some point in 2006"
and that Greenspan's successor "will quickly be confronted with the necessity
to lower rates once again." It must be noted that Gross made these comments
before Hurricane Katrina. Even in the weeks preceding
Katrina, rising oil prices raised concerns about the ongoing health of the economy.
Those risks have increased following the disruption of oil production and refining
facilities in the Gulf, as well as damage to a vital port. But higher inflation
is something the Fed must also guard against, and if that proves to be the predominant
worry, short-term rates will keep climbing.
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