The Interest Rate EffectFebruary 6th, 2018 by Tanner Wrisley
You hear about it all the time, and especially recently – beware, interest rates are rising! But why does this make people worried? The Fed is raising them on purpose, so how could this be a bad thing? Doesn’t this just mean I get more return on my bonds? Hopefully, I can help clear the picture some while explaining the economics behind a rising interest rate environment.
Interest rates are just the cost of borrowing money. Your credit card has an interest rate because a bank is paying for your purchases up front and lending you that money. Usually, if you do not pay the balance off by a certain time, you have to pay an amount above the principal determined by an interest rate. When you buy a bond, the roles are reversed, and you are the one lending money to a company or government and therefore receiving interest.
Now imagine this from a corporate perspective. If a company is deciding to expand their operations, one of the factors that come into play is the cost of borrowing to fund this expansion. If interest rates are low, companies are more incented to borrow to pursue growth strategies. However as interest rates rise, more and more companies will think twice about borrowing as the costs rise for servicing the debt.
So how does the Fed fit into this story? They control the discount rate (Fed lending to Banks), which pressures the fed funds rate (banks lending to other banks), which pressures the rest of the market’s interest rates. The Fed’s job as a central bank is to maximize employment and keep prices stable without high inflation. This is called the Fed’s dual mandate and the tool used to accomplish this mandate is their control over the discount rate.
Curbing inflation is very important to an economy. When things start moving too fast, the value of currency starts to drop rapidly. For example, post-WWI Germany had a severe version of inflation called hyperinflation. Prices in Germany were rising 30,000% per month or doubling every two days. Pictures depict individuals burning lumps cash in their fireplaces because it was cheaper than going out and buying wood. Anyone who was holding their money in cash was losing 50% of their buying power a day. This was an extreme situation, but the concept applies to any period of rapid inflation; the value of the underlying currency gets tarnished and it becomes less and less valuable compared to other currencies and goods to the point where it becomes difficult to keep up with the rising prices.
Interest rates in the United States have been historically low since the recession in 2008 after the Fed employed a strategy called quantitative easing (buying government bonds or other financial assets), which helped to stabilize the economy. Now the economy is starting to show more signs of strength. Unemployment is very low (4.1%) and corporate earnings are beating expectations, showing that businesses are growing. But, as the economy heats up, it is the Fed’s job to make sure it does not overheat. By raising interest rates, the Fed can slow down the rate at which businesses borrow and therefore slow down the growth process to a manageable rate. However, they must walk a fine line because if they raise rates faster than the market is expecting, there could be adverse effects on businesses and investors. This may be what we saw when the DOW dropped over a thousand on Monday. The general sentiment amongst investment professionals as stated in a Wall Street Journal article, is that “traders have grown more worried in recent days about rising inflation that could cause the Federal Reserve to raise rates more vigorously.” Rate hikes generally put negative pressure on the stock market, but this is a smaller price to pay than having to use cash as fuel for your living room fire.
By Tanner Wrisley