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Increasing Interest Rates Simplified (And How They Affect You)

in Assets, Economics

Let’s jump right in shall we? This post is going to be slightly more academic and dry in its presentation, it is about a major piece of economics (a subject close to my heart) after all. However, I’m going to do my best alleviate as much as I can. Economics can be fun and interesting, or else I never would have majored in the subject.

Raised Interest Rates, You Say?

Yup, the Federal Reserve has finally raised interest rates for the first time since 2006. They voted to increase it do to several signals they believe indicate the economy has recovered enough. The interest rate has remained at a historic low since the beginning of 2009 due to all of the Quantitative Easing going on, or QE as it is better known. Before I go on with positives and negatives and effects of the rate hike, you should know that a rate hike was inevitable, and – in the grand scheme of things – is a good thing for the economy, as there is an ideal place for things to be sitting. It should also be noted that the increase was extremely minor. An increase of .25 from .25 to .50. So, we’ll get on with the good, the bad, and the ugly here.

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Nothing can go up forever.

The Good

Even though the hike was a relatively minor one (and as can be gleaned from the previous link, it will be hiked successively higher over the next couple of years), there are several positive effects raising the interest rate can have.

  1. Bonds, Savings Accounts, CDs, Money Market Funds, etc. Get a Bump
    1. All of the above instruments are affected heavily by the prevailing interest rate in the market.
    2. This means that bonds will yield higher cash flows, and the interest from savings accounts (and the other listed savings instruments) will be higher as well. Bonds are much more complicated, but this is a general outline.
  2. Saving increases
    1. As interest rates increase, saving becomes a more attractive option (this is always a great thing in the Learning Guy’s eyes!). An obvious consequence is that saving leads to a more secure present and future.
    2. Obviously when saving increases, spending decreases. When people spend less, they tend to reduce their spending on unnecessary items (such as TVs, boats, etc.), and spend money on necessities.
  3. We can more easily control inflation
    1. You might think of inflation as a large negative, but actually, it can play a positive role. Inflation has been very low in recent years. The aim of the Federal Reserve is 2%.
    2. This can lead to cheaper imported goods, and a stronger currency relative to other major economies.
    3. We can prevent DEflation. Deflation sounds good because it means that goods become cheaper because each dollar is worth more, but this can lead to unemployment, and it can lead to stagnant or falling wages.
  4. Stock prices normalize
    1. In periods of low interest rates, stocks become very desirable (since returns on savings vehicles and debt instruments are low), and due to this can become more manipulated and illogical as people start throwing money at them
    2. When interest rates are high stocks begin to be traded on their actual tangible assets such as cash holdings, a more correct Price-to-Earnings (P/E) ratio, etc.

The Bad

  1. Stock prices drop
    1. As an inverse of the above, when stock prices normalize, they tend to lose value, so any stock investments will most likely decrease in value.
  2. Domestic goods become more expensive relative to imported goods
    1. As the interest rates rises, goods produced at home will become less desirable, so companies which produce goods domestically will suffer to some degree.
  3. Spending drops
    1. When spending by consumers drops, companies tighten their belts due to decreased profits.
    2. This can manifest in various ways from lower stock prices to layoffs

The Ugly

  1. Mortgage rates will increase, potentially a couple of percent
    1. This could translate into thousands and thousands of dollars over the life of the loan in added interest.
    2. This is when individuals with variable rate mortgages get screwed quite hard.
  2. Everyone with a balance on their credit card could potentially be affected by an increase in the interest rate (although, if you have been following the learning guy for any amount of time, you wouldn’t be affected by this!)
    1. As a reminder, always pay the full balance of your card off every month, unless you are on fire, in the middle of a corn field, and need it to call in an air drop for water.
  3. As a personal aside, one of my credit cards has already increased its interest rate by .25%
  4. This could translate into tens, hundreds, or thousands of dollars lost as well.

As you can see, there are some optimistic things to take away from this very minor interest rate hike. First, the Fed made this move because they believe the economy is recovering in many different sectors, which is always nice to hear. Second, we may finally see some sanity coming back to the financial markets, as there may now finally be a decent alternative to stocks, since interest payouts will begin to increase. Finally, savings will increase. This is an amazing thing to hear. People in general in the US need all the help they can get with saving money (especially since the historical savings rate has been around 6-8%, and has been an abysmal approximate 5% low over recent years).

Also, some words of advice for all of you people continually trying to learn and better yourselves out there. If you’re thinking of buying a house, now might be the time to take the plunge and lock in at a fixed interest rate, considering interest rates are most likely only going to go up. Also, the incentive will only increase to ensure your credit card is paid off on time. Finally, a true investor is someone who makes investments and holds onto them without emotions coming into the picture. However, it may be time to blow the dust off of your investments, and take a look at their composition. Are you 80% in stocks? It might be time to consider a more risk averse portfolio in the near future to avoid stock losses if a market correction occurs.

For a general overview of how interest rates affect various markets and instruments, check out Investopedia! Got any questions, comments, or concerns? Feel free to post the comment below or head on over to the forum to start the topic up! Thanks for reading, and happy investing.

-That Learning Guy




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