Changes in interest rates can have both positive and negative effects on the U.S. markets. When the Federal Reserve Board (the Fed) changes the rate at which banks borrow money, this has a ripple effect across the entire economy. Below, we will examine how interest rates can have an effect on the economy as a whole, the stock and bond markets, inflation and recessions.
Tutorial: Economics Indicators To Know
How Interest Rates Affect Spending
With every loan, there is a possibility that the borrower will not repay the money. To compensate lenders for that risk, there must be a reward: interest. Interest is the amount of money that lenders earn when they make a loan that the borrower repays, and the interest rate is the percentage of the loan amount that the lender charges to lend money.
The existence of interest allows borrowers to spend money immediately, instead of waiting to save the money to make a purchase. The lower the interest rate, the more willing people are to borrow money to make big purchases, such as houses or cars. When consumers pay less in interest, this gives them more money to spend, which can create a ripple effect of increased spending throughout the economy. Businesses and farmers also benefit from lower interest rates, as it encourages them to make large equipment purchases due to the low cost of borrowing. This creates a situation where output and productivity increase. (Traders rejoice when the Fed drops the rate, but is it good news for all? Find out in How Do Interest Rate Cuts Affect Consumers?)
Conversely, higher interest rates mean that consumers don't have as much disposable income and must cut back on spending. When higher interest rates are coupled with increased lending standards, banks make fewer loans. This affects not only consumers, but also businesses and farmers, who cut back on spending for new equipment, thus slowing productivity or reducing the number of employees. The tighter lending standards mean that consumers will cut back on spending, and this will affect many businesses' bottom lines. This will cause the businesses to reduce the number of employees that they have and to hold off on any major equipment purchases. (For more information, read How Much Influence Does The Fed Have?)
The Effect of Interest Rates on Inflation and Recessions
Whenever interest rates are rising or falling, you commonly hear about the federal funds rate. This is the rate that banks use to lend each other money. It can change daily, and because this rate's movement affects all other loan rates, it is used as an indicator to show whether interest rates are rising or falling.
These changes can affect both inflation and recessions. Inflation refers to the rise in the price of goods and services over time. It is the result of a strong and healthy economy. However, if inflation is left unchecked, it can lead to a significant loss of purchasing power.
To help keep inflation manageable, the Fed watches inflation indicators such as the Consumer Price Index (CPI) and the Producer Price Index (PPI). When these indicators start to rise more than 2-3% a year, the Fed will raise the federal funds rate to keep the rising prices under control. Because higher interest rates mean higher borrowing costs, people will eventually start spending less. The demand for goods and services will then drop, which will cause inflation to fall. (Find out why economists are torn about how to calculate inflation in The Consumer Price Index Controversy.)
A good example of this occurred between 1981 and 1982. Inflation was at 14% a year and the Fed raised interest rates to 20%. This caused a severe recession, but it did put an end to the spiraling inflation that the country was seeing. Conversely, falling interest rates can cause recessions to end. When the Fed lowers the federal funds rate, borrowing money becomes cheaper; this entices people to start spending again.
A good example of this occurred from 2001 to 2002, when the Fed cut the federal funds rate to 1.25%. This greatly contributed to the economy's 2003 recovery. By raising and lowering the federal funds rate, the Fed can prevent runaway inflation and lessen the severity of recessions. (To learn more, read The Federal Reserve's Fight Against Recession and The Impact Of Recession On Businesses.)
How Interest Rates Affect the U.S. Stock and Bond Markets
Investors have a wide variety of investment options. When comparing the average dividend yield on a blue-chip stock to the interest rate on a certificate of deposit (CD) or the yield on a U.S. Treasury bond (T-bonds), investors will often choose the option that provides the highest rate of return. The current federal funds rate tends to determine how investors will invest their money, as the returns on both CDs and T-bonds are affected by this rate.
Rising or falling interest rates also affect consumer and business psychology. When interest rates are rising, both businesses and consumers will cut back on spending. This will cause earnings to fall and stock prices to drop. On the other hand, when interest rates have fallen significantly, consumers and businesses will increase spending, causing stock prices to rise.
Interest rates also affect bond prices. There is an inverse relationship between bond prices and interest rates, meaning that as interest rates rise, bond prices fall, and as interest rates fall, bond prices rise. The longer the maturity of the bond, the more it will fluctuate in relation to interest rates. (Learn the basic rules that govern how bonds are priced in Bond Market Pricing Conventions.)
One way that governments and businesses raise money is through the sale of bonds. As interest rates move up, the cost of borrowing becomes more expensive. This means that demand for lower-yield bonds will drop, causing their price to drop. As interest rates fall, it becomes easier to borrow money and many companies will issue new bonds to finance expansion. This will cause the demand for higher-yielding bonds to increase, forcing bond prices higher. Issuers of callable bonds may choose to refinance by calling their existing bonds so they can lock in a lower interest rate.
Interest rates affect the economy by influencing stock and bond interest rates, consumer and business spending, inflation, and recessions. However, it is important to understand that there is generally a 12-month lag in the economy, meaning that it will take at least 12 months for the effects of any increase or decrease in interest rates to be felt. By adjusting the federal funds rate, the Fed helps keep the economy in balance over the long term. Understanding the relationship between interest rates and the U.S. economy will allow us to understand the big picture and make better investment decisions. (For related reading, see How Interest Rates Affect The Stock Market, Trying To Predict Interest Rates and It's In Your Interest.)
EconomicsLearn about how rising U.S. interest rates affect the U.S. dollar and where the dollar could be heading once the rising rate cycle begins again.
Investing BasicsLearn why interest rates are one of the most important economic variables and how every individual and business is affected by rate changes.
EconomicsAfter the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
Credit & LoansThese terms may sound the same, but they mean very different things for homebuyers.
Options & FuturesInvesting during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
InsuranceTough times call for desperate measures, but is raiding your life insurance policy even worth considering?
InvestingThe Hunger Games's fictitious nation of Panem has technology, black markets, and government. But, we know precious little about Panem's economy and the reasons for its rampant inequality.
EconomicsFind out why China bothers Donald Trump so much, and why the 2016 Republican presidential candidate argues for a return to protectionist trade policies.
Fundamental AnalysisA decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to.
Credit & LoansAdjustable rate mortgages can save borrowers money, but they can't go into it blind. In order to benefit from an ARM, you have to understand how it works.
A bond's coupon rate has a large effect on its market price because it dictates the amount of income the bond generates per ... Read Full Answer >>
The S&P 500 index includes dividends. As of March 2015, the dividend yield for the S&P 500 was 1.91%. This is below ... Read Full Answer >>
Growth in the financial services sector can be broadly divided into two periods: growth before 1980 and growth since 198 ... Read Full Answer >>
For investors and savers seeking principal protection on an investment, a certificate of deposit (CD) can be a smart addition ... Read Full Answer >>
There are several different types of real estate investment trusts (REITs) including equity REITs, mortgage REITs and hybrid ... Read Full Answer >>
Secured loans are better for the borrower than unsecured loans because the loan terms are more agreeable. Often, the interest ... Read Full Answer >>