Why does the Federal Reserve cut interest rates when the economy begins to struggle? The theory is that by cutting rates, borrowing costs decrease, and this prompts businesses to take out loans to hire more people and expand production. The logic works in reverse when the economy is hot.
When interest rates change, there are real-world effects on the ways that consumers and businesses can access credit to make necessary purchases and plan their finances. It even affects some life insurance policies.
Here, we take a look at the impact on various parts of the economy when the Fed changes interest rates, from lending and borrowing to consumer spending to the stock market. This article explores how consumers pay more for the capital required to make purchases and why businesses will face higher costs tied to expanding their operations and funding payrolls when the Fed changes rates. But the preceding entities are not the only ones that suffer due to higher costs, as this article explains.
- Central banks cut interest rates when the economy slows down in order to re-invigorate economic activity and growth.
- Rates go up when the economy is hot.
- The goal of cutting rates is to reduce the cost of borrowing so that people and companies are more willing to invest and spend.
- Interest rate changes spill over to many facets of the economy, including mortgage rates and home sales, consumer credit and consumption, and stock market movements.
- Interest rates and inflation have a direct relationship, which means that rates rise in order to keep inflation in check.
Forces Behind Interest Rates
Interest Rates and Borrowing
Lower interest rates directly impact the bond market, as yields on everything from U.S. Treasuries to corporate bonds tend to fall, making them less attractive to new investors. Bond prices move inversely to interest rates, so as interest rates fall, the price of bonds rises.
Likewise, an increase in interest rates sends the price of bonds lower, negatively impacting fixed-income investors. As rates rise, people are also less likely to borrow or re-finance existing debts, since it is more expensive to do so.
The Prime Rate
A hike in the Fed's rate immediately fuels a jump in the prime rate, which is referred to by the Fed as the Bank Prime Loan Rate. The prime rate represents the credit rate that banks extend to their most credit-worthy customers.
This rate is the one on which other forms of consumer credit are based, as a higher prime rate means that banks will increase fixed- and variable-rate borrowing costs when assessing risk on less creditworthy companies and consumers.
Credit Card Rates
Working off the prime rate, banks determine how creditworthy other individuals are based on their risk profile. Rates are affected for credit cards and other loans because both require extensive risk-profiling of consumers seeking credit to make purchases. Short-term borrowing will have higher rates than those considered long-term.
Money market and certificate of deposit (CD) rates increase because of the uptick of the prime rate. In theory, that should boost savings among consumers and businesses because they can generate a higher return on their savings.
On the other hand, the effect may be that anyone with a debt burden would instead seek to pay off their financial obligations to offset the higher variable rates tied to credit cards, home loans, or other debt instruments.
U.S. National Debt
A hike in interest rates boosts the borrowing costs for the U.S. government, fueling an increase in the national debt and increasing budget deficits. According to the Committee for a Responsible Federal Budget, the estimated total budget deficit from 2022 to 2031 will be $12.7 trillion. Increasing rates by just half a percentage point would increase the deficit by $1 trillion.
National debt as a percentage of GDP is expected to be 107.5% in 2031. If rates were 50 basis points higher, this would increase to 110.6% of GDP.
When interest rates rise, it's usually good news for banking sector profits since they can earn more money on the dollars that they loan out. But for the rest of the global business sector, a rate hike carves into profitability.
That’s because the cost of capital required to expand goes higher. That could be terrible news for a market that is currently in an earnings recession. Lowering interest rates should be a boost to many businesses' profits as they can obtain capital with cheaper financing and make investments in their operations for a lower cost.
Auto Loan Rates
Auto companies benefited immensely from the Fed’s zero-interest-rate policy, but rising benchmark rates will have an incremental impact. In theory, lower interest rates on auto loans should encourage car purchases, but these big-ticket items may not be as sensitive as more immediate needs borrowing on credit cards.
A sign of a rate hike can send home borrowers rushing to close on a deal for a fixed loan rate on a new home. But mortgage rates traditionally fluctuate more in tandem with the yield of domestic 10-year Treasury notes, which are largely affected by interest rates. Therefore, if interest rates go down, mortgage rates will also go down. Lower mortgage rates mean it becomes cheaper to buy a home.
Higher interest rates and higher inflation typically cool demand in the housing sector. For example, on a 30-year loan at 4.65%, homebuyers can anticipate at least 60% in interest payments over the duration of their investment.
But if interest rates fall, the same home for the same purchase price will result in lower monthly payments and less total interest paid over the life of the mortgage. As mortgage rates fall, the same home becomes more affordable—and so buyers should be more eager to make purchases.
The federal funds rate influences the prime rate, which influences all other interest rates, such as the rates on mortgages and personal loans.
A rise in borrowing costs traditionally weighs on consumer spending. Both higher credit card rates and higher savings rates due to better bank rates provide fuel for a downturn in consumer impulse purchasing. When interest rates go down, consumers can buy on credit at a lower cost. This can be anything from credit card purchases to appliances purchased on store credit to cars with loans.
Inflation is when the general prices of goods and services rise in an economy, which may be caused by a nation's currency losing value or by an economy becoming over-heated—i.e. growing so fast that demand for goods is outpacing supply and driving up prices.
When inflation rises, interest rates are often increased as well, so that the central bank can keep inflation in check (they tend to target 2% a year of inflation). If, however, interest rates fall, inflation can begin to accelerate as people buying on cheap credit can begin bidding up prices once again.
The Stock Market
Although profitability on a broader scale can slip when interest rates rise, an uptick is typically good for companies that do the bulk of their business in the United States. That is because local products become more attractive due to the stronger U.S. dollar.
That rising dollar has a negative effect on companies that do a significant amount of business on the international markets. As the U.S. dollar rises—bolstered by higher interest rates—against foreign currencies, companies abroad see their sales decline in real terms.
Companies like Microsoft, Hershey, Caterpillar, and Johnson&Johnson have all, at one point, warned about the impact of the rising dollar on their profitability. Rate hikes tend to be particularly positive for the financial sector. Bank stocks tend to perform favorably in times of rising hikes.
Although the relationship between interest rates and the stock market is fairly indirect, the two tend to move in opposite directions; as a general rule of thumb, when the Fed cuts interest rates, it causes the stock market to go up and when the Fed raises interest rates, it causes the stock market as a whole to go down. But there is no guarantee of how the market will react to any given interest rate change the Fed chooses to make.
What Is the Overall Effect of Interest Rate Changes?
As interest rates increase, the cost of borrowing money becomes more expensive. This makes buying certain goods and services, such as homes and cars, more costly. This in turn causes consumers to spend less, which reduces the demand for goods and services. If the demand for goods and services decreases, businesses cut back on production, laying off workers, which increases unemployment. Overall, an increase in interest rates slows down the economy. Decreases in interest rates have the opposite effect.
How Do Interest Rate Increases Affect Inflation?
Increases in interest rates cause a decrease in inflation. When interest rates increase, this causes goods and services to become more expensive because borrowing money becomes more expensive. The cost of a house or car will cost more if the interest rate is higher. This causes consumers to spend less, reducing the demand for goods and services. When demand decreases, prices decrease too, which reduces inflation.
Who Controls Interest Rates?
A nation's central bank controls interest rates. Adjusting interest rates to spur or slow down the economy is part of monetary policy, which a central bank is responsible for. Governments are responsible for fiscal policy, which involves adjusting taxes.
The Bottom Line
When the economy falters, the central bank can step in to cut rates. The Federal Reserve is keen to react to rising inflation or a recession using this tool to lower the cost of borrowing so that firms and households can spend more and invest; with the goal of keeping the economy chugging along smoothly.