Interest rates are a huge topic of interest in our today’s economy and many people are interested in the dynamics of it. This is because interest rates hit the wallet (U.S News). In any economic set up, there will always be need for extra money for example in a family, people might borrow money to buy home appliances or cars, businesses can borrow money to facilitate organic growth as well as inorganic growth, governments can borrow money to fund different activities within a country etc.
The Federal Reserve Bank which is the United States’ Central Bank, uses its authority to set a benchmark for these interest rates. This is usually focused on influencing the rate of growth of the nation’s economy as well as attaining a certain inflation rate (U.S News). With that, a lower rate of interest means that borrowers can borrow money for cheaper and this has notably been a tool for promoting economic activities by both businesses and consumers. Financial advisors however advise their clients to pay off high-interest bearing debt and focus more on saving money (U.S News). Rather go to bed without dinner than rise in debt – Benjamin Franklin.
In this paper, I am going to discuss why the Federal Reserve wants to raise the rates, how that process is conducted, which sector of the economy is affected and how and lastly, I will discuss what the benefit is of raising the interest rates. Finally, I will state what my opinion is concerning such a move.
According to the Oxford dictionary, interest rates are the proportions of a loan that is charged to the borrower, typically expressed as an annual percentage of the loan outstanding. In finance, however, the definition is simplified to the cost of borrowing money either by individuals, institutions, private companies, government etc.
The Federal Reserve
Before I dig into the main issue, I would like to first understand what the Federal Reserve is. This is the main bank of the United States of America government. The establishment dates to December of 1913 where the United States Congress passed the law to start it. It is charged with the responsibility among others to govern all other banking institutions in the country. The institution is ran by a Board of Governors. Other responsibilities are to adjust monetary policy, maintain inflation within certain percentage rates, setting the benchmark for interest rates and serves and lender of last resort to other banks.
The Federal Funds Rate
This refers to the rate that banks and other depository institutions lend reserve balances to other banks on an overnight basis. Reserve balances are the excess balances held at the Federal Reserve to maintain the reserve requirement. This rate also influences the short-term interest rates for everything, be it auto loan, credit card etc. which are based of the prime lending rate determined by the federal funds rate. The prime lending rate is now the interest rate charged by the bank to customers.
Below is a chart of the federal funds rate for 20 years www.investopedia.com
FEDERAL OPEN MARKET COMMITTEE (FOMC)
The FOMC is the branch of the Federal Reserve Board that is charged with the responsibility of determining the direction of monetary policy.
The FOMC increases the federal funds rate by decreasing the money supply in the system which in turn pushes interest rates higher. This situation lowers the market equilibrium of the demand and supply of money in the economy. On the flip side, the federal funds rate is usually taken off whenever the government wants to grow and expand the economy. Along with that the federal funds rate is also used to control inflation.
Currently, the Federal Reserve is announcing intermittent increase of the interest rates through the federal funds rate. Traditionally, the federal reserve controls the interest rates in the short run. This comes at a time when the United States government enacted a law on new taxes. According to the former Federal Reserve chairman, this move to increase the benchmark interest rates will not have a huge impact on the economy as a whole because the lower taxation rate means that firms and individuals are going to have more disposable income.
To manage inflation, the Federal Reserve looks at these factors: The consumer price index and the producer price index. The consumer price index (CPI) basically the measure of the weighted average prices of a basket of good and services. Producer price index (PPI) on the other hand is the measure of the average change on selling prices received by domestic producers of goods and services within a period of time.
When the percentage of the CPI and PPI indices rise more than 2-3%, the Federal Reserve will rise the federal funds rate. Once that is done, the lending institutions consequentially raise their rates and eventually consumers’ spending is lessened controlling the inflation due to the low demand for goods and services and therefore the prices fall as well.
WHO DOES THIS INCREASE AFFECT ?
The increase in the interest rates affects a variety of sectors within the economy. First off, are the households. Higher interest rates translate to lower disposable income by the households due to higher interest payments for example auto loans and credit cards. In addition to that, the higher rate discourages borrowing and therefore individuals do not have much access to extra money for immediate use. Also, the interest rate increase might also affect the eligibility for certain individuals to qualify for personal lines of credit. Overall, this will affect the disposable income amongst individuals, again, leading to less spending.
How does the higher interest rates affect the interest rate deductible? Before I get into the specifics of it, an interest rate deductible is an amount of money excluded from the total taxable income that an individual paid. There are kinds if interest deductions that an individual is able to deduct from total taxable income: home mortgage and home equity loan interest and margin account interest. Well, from a surface point of view, one would expect that a higher interest rate would lead to a higher interest payment resulting to a higher deductible but with the new Tax Cuts and Jobs Act, there is a cap, which limits the amount of interest payment an individual can deduct from their taxable income.
Higher interest rates not only discourage individuals to borrow money but also businesses. It is a bit tougher at this level because is a double cut for businesses. When consumers do not have more disposable income, they go less on spending which in turn lowers the demand for goods and services causing. When the demand goes down, that means that the businesses will not have to produce as much products because the demand is not there. This hurts profitability because the businesses will potentially have to lower the prices of goods and services.
On a different note, the higher cost of borrowing increases companies weighted cost of capital (WACC) which by definition is the rate that a company is expected to pay on average to all its security holders to finance its assets. Breaking it down further, WACC has several components. First off, is the different weights of different components: debt, equity (preferred and common stock), then there is the cost of each. An increase in the interest rates increases the cost of debt and consequentially increasing the overall WACC.
An increase in WACC will have a negative effect on the Net Present Value (NPV) of a company. In the calculation of NPV, WACC is used as the discount rate. When this number goes up, it leads to a negative NPV value which from a finance standpoint, that would be unfavorable. A negative NPV should be avoided because it shows that the company or the project being evaluated, if implemented, lowers the value of the organization.
Just like individuals, businesses are also allowed to deduct their interest paid during the year so as to lower the taxable income. This is done to lower the businesses’ tax liability. This interest deductible is dependent on the interest rate that the company acquired the debt at. A higher interest rate would mean a higher deductible. This however is not necessarily an enticement for businesses because like I mentioned earlier a higher interest rate increases he overall cost of capital hurting the Net Present Value. Before the year 2018 businesses were able to deduct their interest payments from the taxable income without much restrictions. After the enactment of the Tax Cuts and Jobs Acts, businesses can now deduct up to 30% of Earnings Before Interest Taxes, Depreciation and Amortization (EBITDA). This discourages businesses from unnecessary spending and borrowing.
Among other factors, when the companies report earnings that are below the analysts’ and investors’ expectations perhaps due to higher interest payments, less revenue from lower sales caused by the factor I highlighted earlier etc., this usually hurts the stock price. Investors, more often than not get emotional over dropping stock prices and most of them end up selling at a lower price than the one they purchased at. Now thinking of higher interest rates which affect almost all businesses that are debt financed, this means that it is likely that the reported earnings by businesses will not be as high as investors and analysts would expect. If this happens then the entire market represented by the main indexes: Dow Jones Industrial, S;P 500 etc. would definitely show a significant drop in value. Having said that, it still remains almost impossible to determine how the market would react to different changes in the economy.
The relationship between interest rates and bond prices in inversely proportional in the sense that as interest rates go up, bond prices fall and vice-versa. For longer term – to – maturity bonds the volatility in response to interest rates is higher as compared to shorter term bonds.
One way that the United States government raises money is by the issuance of bonds. When the Federal Reserve raises the federal fund rates which eventually leads to increase in interest rates, investors start to think that owning government issued securities such as T-bills and treasury bonds as less riskier investments to opt in as compared to stocks. This causes the interest rates on the T-bills and T-bonds to go up. The interest rate in these kind of securities is basically the risk-free rate. When the risk-free rate increases the total expected rate of return for stocks increases. This potentially would mean that the market risk premium would go down. If investors realize that they are getting a less premium for bearing more risk, this might discourage them from investing in stocks and therefore opt for bonds.
From the above discussion, a hike in the interest rates has seemingly affected most of the sectors of the economy negatively. Let’s take a closer look at the banking industry. This industry benefits from increasing interest rates. Considering institutions like banks, insurance companies and brokerage companies, an increase in interest rates increases the yield of the huge amount of cash these firms hold for their customers.
In this regard, banks usually invest the cash holdings at a higher yield. As a rule, banks also pay out interest to the customers who own the cash. They make their profit by paying a lower interest to the customers as compared to the one they receive from investing the customers’ cash deposits.
Another way that banks benefit from rising interest rates indirectly is that in a country that has a steady economic growth and the bond yields are rising, there usually is a demand for loans. As the interest rates rise, the return on these loans also increase from the increased spread between the federal funds rate and the rate that the banks charge the customers.
In conclusion, the move by the Federal Reserve bank to increase interest rate will have effects as shown above. The main objective according to researchers was to control inflation. As they work together to achieve that, different sectors within the economy will be affected. This is not the first time the Federal Reserve is making such a move. With different economic cycles, periodically the central bank will continue to exercise different measures to make sure everything is within check.
How Do Interest Rate Changes Affect the Profitability of the Banking Sector?” Investopedia, Investopedia, 8 Jan. 2018, www.investopedia.com/ask/answers/041015/how-do-interest-rate-changes-affect-profitability-banking-sector.asp.
“News, Rankings and Analysis on Politics, Education, Healthcare and More.” U.S. News & World Report, U.S. News & World Report, www.usnews.com/.