What Are These Rates That Appear To Be So Interesting?

Date: December 17, 2016 11:40 pm
Author: Ezra Berman

Too often does one come across the term “interest rate(s)” and not know exactly what it means or how it affects the economy. Nonetheless, it is essential to have a basic understanding of interest rates, as they are one of the key drivers of the economy.

Before being able to understand how interest rates affect the economy, it is necessary to know what precisely they are. Simply, the interest rate is the fee that a borrower pays to the lender for the use of assets. The reason for this fee is to compensate the lender for use or loss of their goods. In the case of borrowing cash, interest is paid to the lender because he or she could have invested the lent money granting potential returns. To illustrate, on a microeconomic level, if Josh lends $100 to Michael for 1 year with 10% interest, Michael is required to pay Josh $110 at year’s end. On a macroeconomic level, if one invests $1000 into a 10 year United States Government Bond as of the December 8th rate, their return on investment would be 2.4%, turning their initial investment of $1000 into $1024. These are simple examples of how interest rates may appear in day-to-day life.

Since the financial crisis in 2008, the government has kept interest rates extremely low in order to strengthen the U.S. economy. The chart below shows how the government moved the federal funds rate (one of the most influential interest rates in the U.S. economy) from late 2007, which was before the crisis, through the end of 2008, when the U.S. was trying to recover from the crisis. The federal funds rate, which is the rate at which banks lend to other banks overnight, tends to set the bar for interest rates in the United States. Prior to the 2008 financial crisis, the U.S. economy was thriving and interest rates were sitting at roughly 4.5%. The reason for the vast decline in rates as the market crashed was part of the Fed’s attempt to help the economy recover. When interest rates are low, the cost of doing business, borrowing, and spending money is lower, thereby pumping money into the economy. However, it can be highly problematic to keep rates close to 0%.

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Leaving interest rates to float around 0% is essentially a disaster waiting to happen. Why is it unhealthy to keep the rates where they are if doing so would seemingly allow the economy to grow indefinitely? Unfortunately, keeping rates artificially low provides tremendous financial instability to the economy. When the market went south in 2008, rates were nearly 5%, providing a cushion to pull them back and stimulate the economy. However, if the market were to have a downturn now, with the rates hovering at 0%, the government would not be able to artificially infuse money into the economy by lowering rates. The economy needs interest rates to be raised so that the government can lower them in a time of desperation, such as the government did in response to the horrors of 2008. If a market crash were to occur with the current rates, the Fed would likely be forced to make rates negative, as many European countries have been forced to do. With all of this said, it is almost certain that the Fed is going to raise interest rates soon, so it is important to understand how that will affect the markets.

Raising the interest rates has an interesting effect both on the stock market and bond market. As bond yields (interest to be earned on the bond) go up, the price of the bond goes down. This can be explained as follows: If one buys a 10 year bond today with a fixed 5% interest for $100, and rates for bonds rise to 10% next week, the same type of bond can now be bought with a better yield. Having the ability to buy the same type of bond previously bought but for a better return on investment, ultimately reduces the value of bonds bought prior to the rate hike because investors can now buy the same bond and receive a higher interest payment. Within the stock market, the vast majority of companies will be hurt by the rise of interest rates because it affects the cost of debt. The cost of debt is essentially the interest a company pays throughout a specific time period, so raising this would ultimately raise corporations’ cost to operate and, therefore, reduce  profits. This will result in a ripple effect of most stocks decreasing in value. Although the bond and stock market may seem like two unconnected entities, this demonstrates how the rising of interest rates intertwines the two and harms the stock market.

Several problematic occurrences arise when lower expected return on stock market investments is coupled with rising bond yield. One of these occurrences is less consumer spending, which, of course, ultimately harms revenue intake for businesses. Although the federal funds rate affects banks, banks affect individuals. Rising rates for banks consequently raises their cost to operate. Due to this, consumer rates for items such as credit cards and mortgages also increase. Since consumers must allocate more money to those bills, households are left with less disposable income which ultimately results in companies generating lower revenues.

The expected upcoming rise of interest rates does not appear on paper to be beneficial to consumers and investors; however, the stock market is forever unpredictable, which makes it interesting to see what the results will be over time.

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This post was written by Ezra Berman

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