When interest rates increase, there are real world effects on the ways that consumers and businesses can access credit to make necessary purchases and plan their finances. This article explores how consumers will 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 Federal Reserve increase the target rate. However, the preceding entities are not the only ones that suffer due to higher costs, as this article explains. (For more, read: How Interest Rates Affect The U.S. Markets.)
The following provides a breakdown of what consumers and businesses can expect as a result of the Federal Reserve’s recent interest rate increase.
Things That Traditionally Increase When the Fed Increases Interest Rates
The recent rise in the Fed funds rate will likely cause a ripple effect on the borrowing costs for consumers and businesses that want to access credit based on the U.S. dollar. That has an impact across numerous credit categories, including the following:
- The Prime Rate: A hike in the Feds rate immediately fueled a jump in the prime rate, which 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 credit-worthy companies and consumers.
- Credit Card Rates: Working off the prime rate, banks will determine how credit-worthy other individuals are based on their risk profile. Rates will be affected for credit cards and other loans as both require extensive risk-profiling of consumers seeking credit to make purchases. Short-term borrowing will have higher rates than those considered long-term.
- Savings: Money market and credit-deposit (CD) rates increase due to the tick up of the prime rate. In theory, that should boost savings among consumers and businesses as they can generate a higher return on their savings. However, it is possible that anyone with a debt burden would seek to pay off their financial obligations to offset 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 and fuel an increase in the national debt. A report from 2015 by the Congressional Budget Office and Dean Baker, a director at the Center for Economic and Policy Research in Washington, estimates that the U.S. government may end up paying $2.9 trillion more over the next decade due to increases in the interest rate, than it would have if the rates had stayed near zero.
Things That Are Largely Unaffected When the Fed Increases Benchmark Interest Rates
- Auto Loan Rates: Auto companies have benefited immensely from the Fed’s zero-interest-rate policy, but rising benchmark rates will have an incremental impact. Surprisingly, auto loans have not shifted much since the Federal Reserve’s announcement because they are long-term loans.
- Mortgage Rates: 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. However, mortgage rates traditionally fluctuate more in tandem with the yield of domestic 10-year Treasury notes, which are largely affected by inflation rates.
Things That Traditionally Decrease When the Fed Increases Interest Rates
- Business Profits: When interest rates rise, that’s typically good news for the profitability of the banking sector, as noted by investment giant Goldman Sachs. 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.
- Home Sales: Higher interest rates and higher inflation typically cool demand in the housing sector. On a 30-year loan at 4.0%, home buyers can currently anticipate at least 60% in interest payments over the duration of their investment. Any uptick is surely a deterrent to acquiring the long-term investment former President George Bush once described as central to “The American Dream.”
- Consumer Spending: 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 a downturn in consumer impulse purchasing. (For more, read How Interest Rates Affect Spending.)
Which Stocks Perform Best When Interest Rates Rise?
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 Corporation (MSFT), Hershey (HSY), Caterpillar (CAT), and Johnson & Johnson (JNJ) have all at one point warned about the impact of the rising dollar on their profitability.
Rate hikes are particularly positive for the financial sector. Banking stocks tend to perform favorably in times of rising hikes, according to Claudio Borio, the head of the monetary and economic department at the BIS. Borio says financial companies favor high-interest rates due to “the positive impact of being able to earn income by lending money out for higher rates over time is bigger than the hit of defaults and income that doesn’t carry interest.” Shares of large banks like JPMorgan Chase & Co. (JPM) and Goldman Sachs Group (GS) have surged in the past six months, both due to factors such as slowing growth in China, and Brexit, and the expectations of a Fed hike.
The Bottom Line
The Federal Reserve first kicked off its process of monetary policy normalization in December, 2015, and raised the Federal funds rate. Now, the speculation is if the rate will be increased from 0.75% to 1% on Wednesday.