The Consequences of Increasing Interest Rates

Jun 24, 2018 by Adam C. Powell, Ph.D.

The Federal Funds Rate in 2018 reached new highs, but nonetheless remained lower than the rates seen during the second term of the Bush Administration:

Although rates remain at historic lows in 2018, they nonetheless represent a component of a series of interest rate hikes that is anticipated by the Federal Reserve to be continued over the next year. Interest rates have risen steadily during the Trump Administration, whereas they were under 1% for the entirety of the Obama Administration.

Given that Jerome Powell (no relation) has stated his commitment to raising interest rates, what does this mean? There are both benefits and drawbacks to this action.

Benefits

• Risk-averse people, such as the elderly, obtain better returns on their savings accounts and certificates of deposit
• Banks have a greater incentive to loan money to people and businesses, as they can receive larger streams of payments for taking on the same degree of risk
• Money moves into the bond market, as bonds offer better returns
• The increased attractiveness of bonds to foreign investors strengthens the nation’s currency
• Insurance companies are able to earn better returns from their reserves

Drawbacks

• Consumer loans become more expensive
• Homes become less affordable, as the monthly cost of paying a mortgage of a given size increases with the interest rate
• Businesses must pay more to borrow money in order to enhance their operations
• The value of bonds sold during a low interest rate environment decline
• The cost of paying revolving debts with variable interest rates (e.g. the national debt, ARM mortgages, and credit cards) increases