The Federal Reserve’s duty is to keep the United States economy stable, avoiding recessions and widespread unemployment while preventing inflation and asset bubbles. The Fed performs this duty by overseeing the United States monetary system, ultimately controlling the increase or decrease in the supply of dollars. The Fed achieves its monetary and economic policy objectives through many means, but primarily through quantitative easing or the more widely known method of raising and lowering interest rates.
One of the primary tools used by the Fed to control the flows of our complex monetary system is its ability to raise and lower interest rates. In a nutshell, when the Fed raises interest rates, inflation goes down, and inflation goes up when the Fed lowers interest rates. This inverse relationship is primarily related to the increase or decrease in financing costs associated with varying interest rates, which affects both borrowers and savers. Banks themselves have to pay higher interest rates on the money they borrow to meet their daily liquidity reserve requirements in a rising interest rate environment.
Like all businesses, to continue making a profit, the bank passes these costs (higher interest rates) to consumers and companies looking for financing. Higher interest rates mean the payments made on these new loans increase which ultimately dissuades consumers from seeking financing for less critical and time-sensitive projects. Additionally, those taking loans at the latest interest rates are now paying more on the loan’s interest and have less funds to spend elsewhere in the economy.
Furthermore, while banks make it harder for borrowers, savers benefit from higher interest rates as banks may now increase the savings yield on idle monies in their accounts. These higher savings yield further incentives for savers to increase the funds in their accounts, ultimately reducing the amount of money they spend elsewhere in the economy. In totality, higher interest rates reduce the supply of dollars in the economy by disincentivizing further borrowing and incentivizing continued saving. These incentives mean that fewer dollars are ultimately chasing the same basket of goods, which should stabilize asset and consumer goods prices.
Unprecedented levels of fiscal stimulus, quantitative easing, and lower interest rates were a part of the Fed’s response to ensure that Covid-19 did not send the United States into a prolonged recession. However, due to the ample supply of dollars circulating in the economy, a constrained supply chain, and now economic hardship stemming from the invasion of Ukraine, inflation has risen past the levels of comfort set by the Fed and is appearing less “transitory” than once predicted. As a result, after setting the Federal Funds Rate to near zero for the past three years, the Fed recently approved a 25 basis point increase, bringing the new rate to a range between .25% to .50%. Additionally, the Fed has hinted at additional increases in the near future, which would further reduce consumer spending.
As previously explained, because interest rates are inversely correlated with inflation, the hope behind these interest rate increases is that the economy takes a slight pause from the historic inflow of funds that have entered the system. This pause would ultimately allow prices to stabilize throughout the economy and give the supply chain much-needed time to catch up with a significantly reduced demand.
For most consumers, increased interest rates should be helpful as they will reduce the price increases that have been shocking the nation. However, if you are looking to purchase a home or are currently paying off debt associated with variable interest rates, you will find that you have fewer funds to spend elsewhere at the end of the day.
To highlight this point, we will look at the monthly payments of a home purchase.
A $400,000 home with 20% down requires a loan amount of $320,000. A 30 year fixed rate loan at 4.5% will ultimately result in a monthly principal and interest payments of $1,900. However, that same home loan at an interest rate of 5.5% (just a 1% increase) now results in $2,100, leaving a purchaser with $200 less a month to spend elsewhere.
In addition to home buying and consumer loans, increased interest rates also tend to slow down the stock market. The reasoning behind this is twofold. On the shareholder side, individual investors typically have less funds to invest on a monthly basis in their savings. On the business side, just like consumers pay a higher rate to borrow, so do businesses. Businesses borrowing funds are often those that are not yet profitable and still trying to grow at higher rates; however, with less capital investment, these growth rates may face increased headwinds and stall out. If these companies are no longer able to hit growth rates set by analysts and investors, price targets for the underlying share price will drop until sufficient liquidity frees up to continue fueling the companies growth again.
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