“The rise in interest rates is a sign that the economy is doing well, but what does this increase entail for you and the U.S. economy as a whole?”
By Oleg Biletsky
Why the Hike?
On Wednesday March 15th, 2017, the Federal Reserve raised its key interest rate by 0.25%, and it was only the 3rd time since the financial crisis of 2008 that the Fed increased interest rates. The increase was widely anticipated after the Federal Reserve Chairwoman Janet Yellen signaled weeks before that the move was coming in March. So what does the Fed rate hike mean? Generally, an increase in interest rates is a signal that the Fed feels confident about the pace of the US economy’s growth. As the Chairwoman Yellen said herself in a press conference, “the simple message is the economy is doing well…we have confidence in the robustness of the economy and its resilience to shocks.” The rate hike is a sign that the economy no longer needs as much assistance from the Fed to operate at a satisfactory level and that businesses and consumers can now afford to pay more to borrow money. The Fed increased its targeted rate from 0.75% to 1.00%, compared to 0% in December 2008 after the collapse of the housing market. What’s more is that the Fed expects to increase its key interest rate twice more in 2017, which signals that the Fed is even more confident about the continuation of the economy’s growth. By raising rates, the Fed aims to prevent the economy from overheating, a process that occurs when the economy’s productive capacity can’t keep up with the growing demand. As we are about to see, higher rates decrease consumer spending and business investment, thus cooling the economy back to safe levels.
Initial Results of a Fed Rate Hike
The traditional effects of an increase in the Fed’s benchmark interest rate are a rise in the prime rate, credit card rates and national debt and a decrease in business profits, home sales and consumer spending. The increase in the prime rate represents a hike in the credit rate that banks extend to their credit-worthy customers. Banks have already increased their prime rates after the Wednesday hike as M&T Bank, BB&T, Citibank and others raised their lending rates from 3.75% to 4%. Along with prime rates, the Fed’s rate hike increases credit card rates, which represents a negative effect on borrowers that apply for credit after the rate hike. Besides prime rates and credit card rates, the rise in the Fed’s benchmark interest rate adds onto the national debt. The rise in interest rates increases the borrowing costs for the U.S. government and thus increases the national debt. According to a 2015 report by the Congressional Budget Office and Dean Baker, a director at the Center for Economic and Policy Research in Washington, the increases in interest rates may lead to a $2.9 trillion rise in US government costs.
The Fed’s Rate Hike also causes a decrease in business profits, home sales and consumer spending. The increase in interest rates traditionally decreases business profits, as the cost of capital businesses must pay to expand spikes from higher rates. The only part of the global business sector that typically benefits from a rate hike is the financial sector, as banks can lend money for higher rates than before. Home sales also typically decrease after a rise in the Fed’s benchmark rate, as higher interest rates and higher inflation decrease the demand for housing. The rate hike also lowers consumer spending, as the rise of borrowing costs means less money on consumption of goods and services. With higher interest rates, consumers have to put aside more money to pay off higher credit card rates and take advantage of higher savings rates in banks. Given all of these traditional effects from a Fed rate hike, what does this rate increase mean for you and the U.S. economy as a whole?
Individual and Macroeconomic Effects
As we discussed above, a Fed rate hike typically increases savings and credit card rates. Therefore, you can take advantage of the higher rates by setting aside more money for savings, but you will also have to spend more money on personal loans. This thus leaves you with less money to spend while shopping for various products. For college students in particular, higher interest rates are likely to raise rates on student loans but only for those with variable rates. Chances are, your loan rate is fixed as 92.5% of federal student loans carry a fixed rate. If your loans have a variable rate, you are likely going to see an increase in your loan rate, but as Jason Delisle, a resident fellow at the American Enterprise Institute, states, this increase won’t dramatically affect your monthly payments.
As far as the effect of the Fed rate hike on the US economy as a whole, the increase will raise the national debt and decrease business profits, consumer spending and home sales. As we mentioned in the last section, the rate hike raises the costs of borrowing for the government, which thus increases the national debt. The increase in interest rates also decreases the prices of bonds, as the demand for present bonds with a lower rate decreases and the price of those bonds goes down to compensate for the loss of demand. Even though this is good for people that are about to enter the bonds market, the rise in interest rates typically reduces confidence among consumers and businesses. Higher rates discourage risky investments and purchases as more money is typically shifted to savings.
Although higher interest rates typically decrease consumer and business spending, the interest rates are still at a relatively low rate to have major effects on you personally and on the economy as a whole. The fact that interest rates are going up is actually a good sign, because the Fed sees the country moving in the right direction and can now loosen its grip on the economy. The Fed’s prediction of increasing the interest rates twice more this year also shows their confidence about the continuation of the economy’s growth. Interest rates are a vital tool of monetary policy and are necessary to regulate the fluctuations of the economy. The Fed rate hike is a sign that the US economy is recovering well from the recent recession, and the likely additional rate increases this year should give us more confidence about where the economy is heading.
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