We all know that the interest rates or monitory policy have the power to shame the economic structure of a country. Interest rates have a very prominent effect on the health of any economy as interest rates directly related to the spending power of consumers and the Inflation and both of these factors plays a very important role in a countries economy.
Whether it is rising or falling interest rates it can affect the market both positive and negatively. Whenever there is a sharp move in the interest rates it not only shakes the market in the short term but also it affect the economy in long run. When the Federal Reserve changes the rate on which the bank borrows money from the reserve bank it tends to affect the overall economic atmosphere as increment will directly translate into consumer spending numbers.
In this blog, we tried to put some light on the negative effects of increasing interest rates. Below are the import effects of interest rate hikes.
Interest Rates Affect on Spending Power
Whether it is a secured loan or unsecured loan there is always a default risk associated with it and that is the reason behind the interest a consumer is willing to pay to not only get the money in advance but because of the risk premium which he has to pay to the bank.
Interest is the main resource of income for lenders and the rate at which they charge interest is called interest rate. An interest rate is the percentage of reward a lender gets from the borrower for providing them the funds in advance which carries a default risk.
in case of insufficiency of funds, a consumer cannot buy the desired goods immediately and the consumer has to wait to get sufficient savings to fulfill their needs and lenders eliminates that waiting period by providing the required funds immediately at a cost of interest. On the other hand interest factor of the lending forces the borrower to use the funds immediately because if the borrower chooses to wait then the borrower has to pay interest for that time period as well.
Low-interest rate attracts a huge number of borrowers because they have to pay lesser in terms of interest and they can also fulfill their needs and requirements immediately without waiting for saving the money to get what they want. For an example if a person wants to buy a car worth $40,000 but he doesn’t have the required funds immediately and the bank is charging only 2% interest rate so instead of waiting to save money to buy that car he can choose to take a car loan as the interest rate is very low and affordable but if the bank charge the interest rate of 10% then he must think about buying the car on loan and may choose not to buy the car on loan.
This is how interest rates affect the spending behavior of consumers. A lower interest rate tends to increase the consumer spending numbers and a higher interest rate tends to control the liquidity in the market and negatively impact the consumer spending numbers.
A high-interest rate not only hurts the consumer spending and affects the spending behavior of consumer but it also affects the overall economic structure as a higher interest rates tends to decrease the demand of goods and services which causes a decreased revenue numbers in businesses which in turn affects the employment numbers as because of the downfall in the profits businesses tends to cut jobs which will increase the unemployment in the country.
High-interest rates and inflation
Inflation refers to the increase in the price of goods and services in a specific time in an economy. A healthy inflation rate shows a constantly growing and healthy economy. However, every economy should keep its inflation under control because a huge change in inflation can result in a big loss for the economy as effects the purchasing power of consumers directly.
Whenever it is a rise or fall in interest rates we usually see a movement in the federal fund rates which is a rate at which banks lend money to other banks. As federal fund rates are directly related to the cost of loans it works as a very reliable indicator in assessing the future movement of interest rates.
The Federal Reserve uses interest rates to control and manage inflation as a change in the federal fund rate directly affects the consumer spending numbers which will help the fed to regulate the inflation effectively by keeping the rising prices under control. Because higher interest rates translate to higher borrowing costs which will result in a lesser spending and higher saving ratio which tends to decrease the demand for goods and services and thus it helps to control the rising price of goods and services.
Interest Rates and its effect on the U.S. Stock and Bond Markets
Interest rates play a very important role in the movement of bond markets and the debt market. Interest rates and bonds share an inverse relationship with each other, which means a higher interest rate means a lower bond price and a lower interest rate means a higher bond price. On the other hand, the value of both the CDs and T bonds are directly related to the Federal Fund Rates because it affects the return on investment in these securities. Rising interest rates tend to attract investors in the bond markets as investors are constantly looking for a higher rate of return giving investment option in the market.
On the other had rising interest rates tends to affect equity investment a bit negatively as because of higher interest rates consumer and business tends to cut back on spending which may result in a fall in earnings of certain companies which in turn translates into a drop in the stock prices.
The Bottom Line
Interest rate hike is not always a wise decision as a rising interest rate also has some adverse effects and it comes with a cost which affects the economy big time. Interest rates not only influence the stock and bond markets but it also affects the spending power of consumers and business which have an effect on the inflation, and recessions as well.