The Federal Reserve has kept its key interest rate steady this month but has acknowledged that prices of essential commodities are inching up to desired range, paving the way for gradual rate hikes in the coming months. The comeback of inflation, by the way, is very evident, with business houses paying more for labor, steel, oil and other supplies.
Fed officials also noted that economic activity continues to rise at a steady pace, while the labor market is expected to remain strong. This calls for investing in banks, insurance and brokerage houses as such institutions will see a ramp up in profits on steady interest rate hikes and stable economic conditions.
Inflation Crawls Higher
As widely expected, the Fed has kept its benchmark short-term interest rate at a range of 1.5-1.75% this month. The central bank had lifted interest rate by a quarter percentage point in March for the sixth time since late 2015.
The Fed, however, reiterated that it is committed to raising rates gradually. After all, core inflation is expected to run near the central bank's 2% benchmark over the medium term, the FOMC statement said.
After being low for quite some time, consumer prices are picking up. The Fed's preferred PCE price index rose to a 12-month rate of 2% for the first time this year. If the volatile food and energy items are excluded, annual inflation went up to 1.9%.
Fed policymakers forecast two more rate hikes this year, per the median estimates, but faster inflation could led to more rate hikes. Traders are now seeing a 94% probability of a rate hike in June, with at least 47% predicting a total of four rate hikes this year.
Economy in Sound Shape, Labor Market Strengthens
The Fed added that "economic activity has been rising at a moderate rate", while business investment "continued to grow strongly." The economy expanded at annualized rate of 2.3% in the first quarter and topped estimates. Such encouraging growth followed a roughly 3% growth rate in the final nine months of last year. In fact, economic growth is expected to rise to 3% for the rest of this year thanks to the recently-passed tax cuts that will boost consumer as well as business spending.
Fed also said that "job gains have been strong, on average, in recent months, and the unemployment rate has stayed low." Monthly job additions averaged a solid 202,000 so far this year and jobless rate remained at a 17-year low of 4.1%. All these developments could fuel faster inflation leading to rate hikes.
Who Stands to Gain From a Rate Hike?
Higher interest rates can boost bank profits as they increase the spread between what banks earn by funding longer-term assets, such as loans, with shorter-term liabilities. The spread between long-term and short-term rates also expands during interest rate hikes because long-term rates tend to rise faster than short-term rates.
Non-banking financial institutions, including insurance companies, asset managers and brokerage firms, should also benefit. Rising rates act as a boon for insurance companies as they derive their investment income from investing premiums, which are received from policyholders in corporate and government bonds. Yields and coupons on these bonds rise in response to a hike in Fed fund rates and bank interest rates. This enables life insurers to invest premiums at higher yields and earn more, expanding their profit margins. Not only investment income, which is an important component of insurers' top line, annuity sales should gain from a raised rate.
Brokerage firms and asset managers also advantage immensely from a rising rate environment since an increase in rates generally concurs during periods of economic strength and upbeat investor sentiments.
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