Updated: Nov 15
Interest rates are a key tool in the financial landscape, with far-reaching implications that touch upon various aspects of the US economy, from inflation to recessions and even the stock and bond markets. The federal funds rate, often at the center of discussions surrounding interest rates, influences numerous financial elements. As this rate fluctuates, it can influence borrowing costs and subsequently affect inflation and economic growth.
Note: this is the third and final installment of our series on rising interest rates.
Inflation and Interest Rates
The correlation between interest rates and inflation is critical. Inflation measures the increase in prices of goods and services over time, and a healthy economy typically has a moderate amount of inflation each year. However, unchecked inflation can erode purchasing power. To manage inflation, the Federal Reserve monitors indicators such as the Consumer Price Index and the Producer Price Index. When these indicators exceed their 2% to 3% annual target threshold, the Fed generally raises the federal funds rate to control rising prices.
The federal funds rate, in turn, indirectly influences various loan rates such as mortgages, credit card and auto loans. Higher interest rates result in increased borrowing costs, leading to reduced household spending and a subsequent decrease in the demand for goods and services. This drop in demand helps alleviate inflationary pressures.
Rising Government Borrowing Costs
Historically, the United States has benefited from low-interest rates. However, when the Federal Reserve raises the federal funds rate, short-term rates on Treasury securities also increase, making federal borrowing more expensive.
As interest rates rise, in conjunction with the United States’ exploding national debt, the government is forced to spend a larger percentage of its annual budget on interest expense.
It is projected that the ballooning interest costs will consume 35% of federal revenues within the next 30 years. In 2023 alone, the interest cost from our national debt already matches our combined investment in Education, Infrastructure and R&D. It is projected that the interest cost will triple to nearly 7% of GDP within the next three decades. The challenge with this reality is that these funds have to be taken from other parts of the federal budget to simply pay the interest expense caused by prior deficits.
Historical Examples and Current Trends
The historical context demonstrates how interest rates can trigger economic shifts. For instance, in the early 1980s, the Fed raised interest rates significantly to combat high inflation, which led to a severe recession but effectively curbed the spiraling inflation. Since 2022, the Fed has increased rates to counter rising inflation in a similar fashion.
Conversely, lowering interest rates has the potential to end recessions, as lower rates entice spending, aiding economic recovery.
The Fed faces the challenge of deciding when to lower rates. If they do it too soon, they may not win the inflation battle. If they do it too late, we may find ourselves in a deep recession.
However, as our national debt grows, and starts consuming more and more of the federal budget, the Fed loses its ability to steer the economy and the debt starts driving the bus.
Impact on Stock and Bond Markets
Rising interest rates also create a more expensive environment for companies seeking capital. Higher borrowing costs limit growth prospects and impact earnings, leading to downward revisions in profit expectations. Consequently, stock prices may decrease, affecting the overall market.
Certain sectors, such as the financial industry, can benefit from interest rate hikes, but most banks are currently in survival mode. Their funding costs have exploded over the past 18 months, and they have not been able to reprice their assets quickly enough to maintain the spread they need to operate profitably.
Current Economic Scenario and Concerns
The current economic landscape presents a challenge due to rising interest rates. The surge in borrowing costs across the board, from mortgages to auto loans poses a real threat to the economy. Factors such as higher gas prices, student loan repayments, ongoing strikes, and potential government shutdowns are anticipated to impact consumer spending and economic growth.
While the economy has experienced robust growth, the forecast indicates a slowdown due to elevated borrowing rates and lingering inflation.
Corporations, especially small and mid-sized firms, are experiencing challenges in debt servicing as earnings moderate. Likewise, households are depleting savings, and rising delinquencies in credit cards and auto loans are becoming evident. Real estate markets are also affected, with higher mortgage rates impacting housing markets.
The challenges in the financial landscape, including potential defaults, signal a need to proceed cautiously.
Interest rates wield significant influence over various sectors of the economy. The interplay between interest rates, inflation, and economic growth forms a complex web that policymakers and market participants must navigate. Striking a balance between curbing inflation and avoiding economic downturns while ensuring financial stability remains a critical challenge in the evolving global economic landscape.
To have a ten out of ten level of confidence that you are going to be OK, no matter what happens to interest rates or the economy, schedule a financial planning meeting with Monotelo.
This article is a general communication being provided for informational and educational purposes only and is not meant to be taken as tax advice, investment advice or a recommendation for any specific investment product or strategy. The information contained herein does not take your financial situation, investment objective or risk tolerance into consideration. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. Any examples are hypothetical and for illustration purposes only. All investments involve risk and can lose value, the market value and income from investments may fluctuate in amounts greater than the market. All information discussed herein is current only as of the date of publication and is subject to change at any time without notice. Forecasts may not be realized due to a multitude of factors, including but not limited to, changes in economic conditions, corporate profitability, geopolitical conditions, inflation or US tax policy. This material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed.
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