Why does the Fed lower interest rates when the economy is struggling and raise them when the economy is thriving? The theory holds that reducing interest rates reduces the cost of borrowing, which encourages businesses to take out loans to hire more workers and expand production.
When the economy is booming, logic works in reverse. Here, we examine the effects of Fed interest rate changes on various aspects of the economy, including lending and borrowing, consumer spending, and stock prices.
Changes in interest rates have real-world effects on consumers' and businesses' access to credit for making necessary purchases and financial planning. Even some life insurance policies are affected.
This article explores how consumers will pay as much for the capital required to make buying and why businesses will face higher costs associated with expanding operations and funding payrolls when the Fed alters the interest rate; however, this article also explains that these entities are not the only ones affected by higher costs.
When the economy slows, central banks reduce interest rates to stimulate economic activity and growth. The goal is to reduce the cost of borrowing so that individuals and businesses are more willing to invest and spend.
Changes in interest rates have a ripple effect on numerous aspects of the economy, such as mortgage rates and home sales, consumer credit and consumption, and stock market fluctuations.
Interest Rates and Borrowing
Lower interest rates have a direct effect on the bond market, as yields on all types of bonds, from U.S. Treasuries to corporate bonds, tend to decline, making them less appealing to new investors. Bond prices move in the opposite direction of interest rates, so as interest rates fall, bond prices rise.
Similarly, an increase in interest rates causes the price of bonds to decline, which is detrimental for investors in fixed-income securities. As rates rise, individuals are less likely to borrow or refinance existing debts, as doing so becomes more expensive.
The Prime Rate
A Fed rate hike prompts an immediate increase in the prime rate (referred to by the Fed as the Bank Prime Loan Rate). The prime rate is the interest rate that banks offer to their most credit-worthy clients.
This rate is the basis for all other forms of consumer credit, as banks will increase fixed and variable-rate borrowing costs when assessing the credit risk of less creditworthy companies and consumers if it rises.
Savings
Because of the increase in the prime rate, money market and certificate of deposit (CD) rates rise. Theoretically, this should increase consumer and business savings because they can earn a higher return on their savings.
On the other hand, as a result of the higher variable interest rates attached to credit cards, mortgages, and other debt instruments, individuals with a high level of debt may seek to pay off their financial obligations.
Credit Card Rates
Banks will determine the creditworthiness of other individuals based on their risk profile and the prime rate. Rates for credit cards and other loans will be altered due to the fact that both require extensive risk profiling of consumers seeking credit to make purchases. Usually short-term loans will have higher interest rates than long-term loans.
U.S. National Debt
National Debt of the United States A rise in interest rates increases the U.S. government's borrowing costs, resulting in a rise in the national debt and rising budget deficits. According to the Committee for a Responsible Federal Budget, the total budget deficit between 2022 and 2031 is projected to be $12.7 trillion. A half-percentage-point increase in interest rates would increase the deficit by $1 trillion.
In 2031, the national debt is projected to reach 107.5% of GDP. If rates were increased by 50 basis points, GDP would increase to 110.6%.
Business Profits
When interest rates rise, it's generally good news for banking sector profits, as banks can earn more on dollars they loan out. For the remainder of the global business sector, however, a rate hike reduces profitability.
Because the cost of capital required for expansion increases. That could be terrible news for a market currently experiencing a decline in earnings. Reducing interest rates should increase the profits of many businesses, as they will be able to obtain capital at a lower cost and make investments in their operations for less money.
Auto Loan Rates
The auto industry has benefited greatly from the Fed's zero-interest-rate policy, but rising benchmark interest rates will have a negligible effect.
In theory, lower interest rates on auto loans should inspire car purchases, but these expensive items may not be as sensitive to interest rate changes as credit card borrowing for more immediate needs.
Mortgage Rates
Typically, mortgage rates fluctuate more in tandem with the yield of domestic 10-year Treasury notes, which are largely influenced by interest rates. However, a rate hike can prompt homebuyers to close quickly on a fixed-rate mortgage loan for a new home. Consequently, if interest rates decline, mortgage rates will also decline. Reduced mortgage rates make it more affordable to purchase a home.
Home Sales
Higher interest rates and inflation typically dampen housing sector demand. On a 30-year loan at 4.65 percent, homebuyers can expect to pay at least 60 percent in interest over the life of their investment.
The federal funds rate affects the prime rate, which in turn affects all other interest rates, including mortgage and personal loan rates.
However, if interest rates decline, the same home with the same purchase price will have lower monthly payments and less total interest paid over the life of the loan. As mortgage rates decline, the same home becomes more affordable, and buyers should therefore be more eager to purchase.
Consumer Expenditures
Historically, a rise in borrowing costs has a negative impact on consumer spending. Higher credit card rates and higher savings rates as a result of better bank rates fuel a decline in consumers' impulsive spending. When interest rates decline, consumers can purchase on credit for less money. This includes purchases made with credit cards, appliances purchased on store credit, and cars financed with loans.
Inflation
Inflation occurs when the general prices of goods and services increase in an economy, which may be induced by a nation's currency losing value or an economy becoming overheated, i.e., growing so quickly that demand for goods exceeds supply, thereby driving up prices.
When inflation rises, interest rates are frequently increased so that the central bank can keep inflation in check (they typically aim for 2% inflation per year). If, on the other hand, interest rates decline, inflation can accelerate as consumers with access to cheap credit bid up prices.
Stock Market
Despite the fact that a rise in interest rates can have a negative impact on the overall profitability of a business, a rise is typically positive for companies that conduct the common business in the United States. This is due to the fact that a stronger U.S. dollar makes local goods more appealing.
This rising dollar has adverse impact on businesses that conduct large business on international markets. As the U.S. dollar appreciates against foreign currencies, as a result of rising interest rates, foreign companies' real sales decline.
Microsoft, Hershey, Caterpillar, and Johnson & Johnson have all, at one point or another, expressed concern regarding the impact of a rising dollar on their profitability. Generally, rate increases are especially beneficial for the financial sector. Typically, bank stocks perform well during periods of rising interest rates.
Although the relationship between interest rates and the stock market is indirect, the two tend to move in opposite directions; when the Fed reduces interest rates, the stock market tends to increase, and when the Fed raises interest rates, the stock market tends to decrease. However, there is no assurance as to how the market will respond to any particular Fed interest rate change.
What Is the Overall Result of Interest Rate Changes?
The cost of borrowing money becomes more expensive as interest rates rise. This increases the price of certain products and services, such as homes and automobiles. Consequently, consumers spend less, which decreases the demand for goods and services. If indeed the demand for goods and services decreases, businesses reduce production, lay off employees, and unemployment rises. A rise in interest rates slows the economy as a whole. Interest rate reductions have the opposite effect.
How Do Interest Rate Increases Affect Inflation?
Inflation decreases as a result of an increase in interest rates. When interest rates rise, goods and services become more expensive because it becomes more costly to borrow money. The price of a home or automobile will increase if the interest rate is higher. This decreases consumer spending, thereby decreasing demand for goods and services. When demand falls, prices fall as well, reducing inflation.
Who Controls Interest Rates?
The central bank of a nation controls interest rates. As part of monetary policy, a central bank is responsible for adjusting interest rates to stimulate or decelerate the economy. Governments are accountable for fiscal policy, which includes tax adjustments.
The Bottom Line
When the economy deteriorates, the central bank is able to reduce interest rates. The Federal Reserve is eager to respond to rising inflation or a recession by reducing the cost of borrowing so that firms and households can spend and invest more, with the aim of maintaining economic stability.
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