For investors, rising rates offer opportunities

The Federal Reserve has signaled a new phase in its battle against inflation, which could mean interest rates will be rising higher — and for longer — than previously expected.

That means new challenges — and opportunities — for consumers and investors who have grown accustomed to an era of super-low interest rates.

For many borrowers, it might be time to consider reducing high levels of variable-rate debt, including credit cards and home equity loans, which will only get costlier to maintain in coming months. Conservative investors, in the other hand, finally can expect to get decent levels of return from money-market accounts and bank certificates of deposit.

Under Chairman Alan Greenspan, the Fed has raised the benchmark overnight lending rate seven times since June, pushing it up to 2.75 percent from a 46-year low of 1 percent. On Tuesday, the Fed signaled it intends to continue tightening credit, warning that “pressures on inflation have picked up in recent months” and risks can be limited only with “appropriate monetary policy action.”

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The Fed’s statement has intensified a debate among economists and market analysts over whether the central bank is likely to accelerate the pace of rate hikes, perhaps with a half-point increase in May or June. In any case there is widespread agreement that short-term rates are likely to be significantly higher a year from now.

Analysts typically expect an overnight rate between 3.5 and 4 percent by the end of 2005, which could boost the commercial bank prime rate up to 7 percent from the current 5.75 percent.  Long-term rates are harder to forecast, but the average 30-year fixed mortgage has crept up to more than 6 percent from less than 5.6 percent in early February, when Greenspan declared that low long-term rates were a “conundrum.”

Here are some areas where rising rates and potentially higher inflation could affect your personal finances and investment decisions:

Savings and bonds
For people who depend on interest income, the past few years have been lousy, with rates on basic money market accounts falling well below 1 percent. Now rates of 2 percent are more typical, rising to 2.7 percent for accounts with $50,000 or more, according to Bankrate.com.

That may not seem terrific, but money market accounts are one of the safest investments available, and rates are likely to go higher.

“If the inflation rate jumps materially, money markets will reflect that, and without the risk of lost principal -- the risk-reward proposition is very good,” said Tony Crescenzi, chief bond market strategist at Miller Tabak & Co.

Certificates of deposit and short-term Treasury securities also are offering a much better payoff than they were a year ago. Experts generally recommend sticking to shorter-term securities that mature in three months to two years and setting up a “laddering” strategy that allows you to continually roll over your investments and take advantage of rising rates.

Treasury Inflation-Protected Securities, or TIPS, have been performing well and offer a good hedge against inflation. Like other fixed-income securities, they can be purchased directly or through specialty mutual funds.

Long-term bonds are riskier now because their value will drop if inflation continues to rise. And Crescenzi suggests that investors steer clear of high-yield “junk” bonds and emerging-market securities, which have dropped in value over the past two weeks. “One wants to trade up the credit quality scale because higher Treasury rates means the risk-reward (tradeoff) tends to worsen for these riskier assets.”

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