Much ado about Interest Rates
When phrases like “interest rate hike” or “Federal Reserve” appear on the news, many of our heads are already looking for the pillow. However, when the Federal Reserve actually increases those interest rates the aftereffects can jolt us awake! That is because even a meager interest rate increase can rock the economic atmosphere that the global economy is currently in.
Interest rate increases/decreases are used to control inflation. Inflation is caused by a lack of demand to save money. On the other hand, negative inflation is caused by a lack of demand to spend money. Right now, our economy is showing signs of a high demand to save and a lack of demand to spend. Capitalism needs consumption and expenditures to grow and thrive. Without it, there isn’t as much growth in the economy.
The more unsteady the economy becomes, the more people want to hold onto their money and save it. Which is one reason why we saw negative 2% inflation in 2009. To increase the demand to spend money, the Federal Reserve decreased the interest rates, which is where we have been ever since.
Many parts of the world are in the negative interest rate territory, including Japan and the European Union. In the United States, the Federal Reserve will be meeting on June 14th to potentially increase the interest rate from 0.5% to 0.75%.
This can, among other things, increase the international demand for investing in the dollar. A stronger dollar is typically bad for U.S. companies as it makes foreign goods cheaper to the American consumer. More bad news may come when mortgages, credit cards, and commercial loans become more expensive, reflecting the higher interest that individuals and companies have to pay. These may reflect poorly for the broad stock market, but historically, the stock market has mixed results following an interest rate hike.
Furthermore, the negatives can be exponentially worse because of high debt in the stock market and in the underlying companies. With a potential interest rate hike, that debt becomes more expensive.
Because of the probable downside of an interest rate hike, the U.S. economy needs to be in a relatively strong economic position beforehand to prevent the possibility of a recession. This leads the Federal Reserve and its Chair, Janet Yellen, to watch certain economic indicators, frequently measuring if the U.S. economy is fit for an interest rate hike.
The various economic indicators were relatively stable through most of spring 2016 and the chance of a rate hike for June 14th was strong. Then on June 3rd, a disappointing report on the labor market showed only 38,000 new jobs were created for the month of May (versus an expected 160,000). Now, says Yellen on June 6th, headwinds to a June hike include domestic demand in the labor market, the Brexit vote on June 23rd (Britain vote to exit the EU), productivity growth, and the inflation outlook. The Fed’s goal to increase interest rates twice in 2016 may be impeded by these factors but Yellen is cautiously optimistic about meeting these goals.
The Federal Reserve’s strategy for years to come will most likely be to gradually increase interest rates. Therefore, obtaining the necessary information and education is important. By doing so, you will not be as surprised by adverse changes in the U.S. stock market and economy if rates are increased. On a positive end, if the interest rate does increase, that is the Federal Reserve saying “We think the economy is doing better now!”