By the time you read this the Fed will probably have raised the interest rate they charge banks by some “nominal” amount, around 0.25%.
To understand where this will take us we must understand where we’ve been.
Historically the feds have raised interest rates to slow the economy and thereby curb inflation, because the primary cause of inflation is too much money in the system. Because there is more money than demand, the money loses its value and prices rise to offset this loss of value. For example, if the economy is so good that you have lots of customers, you will raise your prices to take advantage of their willingness to buy your products. You may also have to raise your prices to maintain your profit margin since your suppliers are also raising their prices.
But here is the conundrum: The Consumer Price Index this year is running around 0%, due mainly to the drop in oil prices. Even without oil, the “core” inflation rate is between 1% and 2%. Further, the GDP is growing at an anemic 2.5%. So with low inflation and slow economic growth, why is the fed raising rates?
In the depths of the Great Recession the Feds reduced its rate to near zero to induce banks to lend. And while it did help stimulate the economy it also had some negative effects. For one, low interest rates resulted in a low savings rate. Ours is amongst the lowest of the major economies, around 5% vs 10% for Germany and 12% for France.
The low rates forced savers to find other places to put their money, most notably the stock market.
Further, many publicly-owned corporations borrowed “free” money to buy back their stocks, to the tune of over $1 Trillion in 2015 alone. This increased their EPS (Earnings per Share) which drove up stock prices. The net result of savers’ money, stock buybacks and other factors is a tripling of the S&P 500 vs. a GDP growth of just 25% since 2009. So now with interest rates going up we can expect more savings, fewer stock buybacks, and a stock market more in line with actual GDP. It may also remove some investor uncertainty, which has accounted for some recent stack market volatility.
In addition, higher interest rates will lower the price of your home and other assets because they will be more difficult to sell. One other consideration: Raising rates will strengthen the dollar, which will make U.S. goods more expensive abroad, but make foreign goods cheaper here. So, fewer jobs in the export sector but increased purchasing power to those with a paycheck.
But to put all this into the proper perspective, the tiny increase of 25 “basis points” is more symbolic than substantive.
And the rate of future increases is expected to be very slow, to give the economy plenty of time to adjust.
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