The Federal Reserve begins its two-day meeting on Wednesday, September 16, and everyone is watching to see if the central bank will raise the United States target interest rate for the first time since the Great Recession. The target rate has been set at historic lows between 0.00% and 0.25% since 2009 in order to stimulate economic growth. When the Fed raises its target interest rate, other interest rates throughout the economy will feel a ripple effect. Hence why many fear a rate hike while others welcome it. (For more, see Timing the Fed Interest Rate Hike.)
Here are some implications of an interest rate rise.
Savers May Benefit
Individuals who deposit money at banks will see the interest rates credited to their savings accounts rise. Certificates of Deposit (CDs), money market accounts and other savings instruments will also see a benefit. Currently, the average interest rate credited on U.S. savings accounts is a paltry 0.09% while a 1-year CD averages a yield of 0.28%.
Of course this benefit s predicated on the assumption that an increase in interest rates won’t be accompanied by an increase in the inflation rate, which can erode the purchasing power of cash savings. One of the factors motivating an interest rate increase is that the economy has recovered enough for positive gains in GDP and employment – both of which can lead to increased inflation. (For more, see The Importance of Inflation and GDP.)
Consumers May Buy Less
Many consumers make purchases on credit, using credit cards, lines of credit or tapping into home equity. The interest rates due on credit cards and consumer loans will tick up. As interest rates rise, the interest payments incurred monthly to service those debts also increase; thus, consumers are discouraged from taking on large amounts of debt, consequently lowering consumption. Consumers may also become more motivated to save more money given the new, higher rates they can earn at banks, which also reduces the amount of money left to spend. (For more, see How Do Interest Rates Coordinate Savings And Investment In The Economy?)
Bond Prices May Fall
Bonds, whether issued by the government or corporations, are debt instruments with prices that are sensitive to interest rates. The price of a bond varies inversely with changes in interest rates: if interest rates go up, bond prices go down. Investors who are holding onto bond portfolios, especially with fixed-rate bonds, can expect the values of those bonds to fall with a rate hike. (For more, see Why Do Interest Rates Tend To Have An Inverse Relationship With Bond Prices?)
However, long-term buy-and-hold bond purchasers who seek to earn cash flows from regular coupon payments and pay little attention to bond values will be able to buy new bonds that offer higher coupon rates.
Stock Prices May Fall
Stock prices are determined by future profits that corporations will generate. At very low interest rates, companies are able to borrow larger sums of money to fund the undertaking of projects that should yield some positive return. In a competitive market, the ability to borrow money at very low rates allows corporations to invest in projects that have narrow profit margins. Raising the cost of borrowing for a company, by even a little bit, can cause these projects to suddenly become losers, reducing profitability and lowering stock prices. Market fundamentals indicate that stocks are relatively expensive compared to historic levels based on earnings multiples, and a higher interest rate environment may make them look even more costly.
Furthermore, as mentioned earlier, consumers may also cut back on purchases, which will negatively affect companies’ revenue numbers and cause further damage to their bottom lines.
Low interest rates have also encouraged traders and speculators to bid up the price of stocks as they are able to purchase shares on margin. If interest rates rise, the cost of leverage will also rise, causing these stock owners to pare down their holdings by selling stocks in the market.
Home Prices May Fall
Consumers may not only cut back on using credit cards, but also on buying homes and property. Most homebuyers use mortgages to finance their homes, and if mortgage rates increase, which will happen with a general rise in interest rates, the cost of owning a home will also climb. The uptick in the cost of homeownership can reduce demand for property.
Housing prices have recovered quite a bit since the housing bubble burst, but mortgage rates on both fixed and variable loans have fallen to historic lows over the past few years. This low interest rate environment helped boost home prices as the favorable mortgage conditions allowed more people to buy homes and enabled existing homeowners to refinance older, higher loans and free up cash flow. (For more, see Real Estate Investing in a High-Interest-Rate Environment.)
Exports May Drop
An interest rate increase could make the U.S. dollar more attractive as an investment, causing the value of the dollar to rise against foreign currencies. A more valuable currency is damaging to exporters since it makes their goods relatively more expensive when translated to other currencies. For example, if a U.S.-made car sells for $30,000 and the exchange rate with the euro is currently $1.10 per euro, it will cost around 27,272 euros in the EU. If the dollar strengthens and the exchange rate rises to $1.05 per euro, the same car will now cost a European consumer 28,571 euros.
The Bottom Line
The Fed is expected to soon raise interest rates above its historic lows of around zero percent for the first time in years. Ultimately, such an interest rate hike signals that the economy is stable and growing, and that key indicators, such as unemployment and GDP growth, point to economic expansion.
There will, however, be some negative implications. Stock prices, bond prices and home prices may all fall as a result, since the persistent low interest rate environment that has existed since 2008--2009 has become one of the drivers of price appreciation in these asset markets. A sudden change to that status quo, even if seemingly marginal at 25 or 50 basis points, it could effectively double the cost of short-term borrowing which could ripple through the economy. (For more, see Is a Rate Hike Already Priced Into the Market?)