The US Federal reserve interest rate is the rate that commercial banks in the US charge one another for borrowing money overnight. The Fed funds rate is determined by the Federal Open Market Committee (FOMC). During the pandemic of Covid-19, the Fed funds rate reached historical lows with rate target ranges between 0% and 0.25%.
As the economy starts to slowly get back on its feet, the US Fed rate is expected to increase throughout 2022. In this article, we will explore the impacts of this increase of the Fed Funds rate in different aspects of the economy.
Cost of borrowing
When consumers borrow money through loans or credit cards, they are charged an interest by the lender for the benefit of using the money needed immediately. The lender faces the risk of not being paid back by the borrower when they lend money to them. To make up for some of that risk, the lender charges the borrower interest. The interest is what determines how expensive it will be to borrow money, or in other words, is the cost of borrowing money.
A higher interest rate means that you will have to pay more in order to borrow, and therefore the cost of borrowing increases. If a consumer has to spend a bigger amount of money on interest, that means that ultimately they will have less income to spend on other goods and services.
As mentioned earlier, the Fed rate is the rate that commercial banks charge one another to borrow money overnight. When the Fed funds rate increases, it will be more expensive for financial institutions to borrow money and these additional interest costs will be transferred to the consumers with loans that have adjustable interest rates and use prime rate as a basis.
These consumers will experience an increase in the interest rate of their mortgage, which translates to a higher monthly mortgage payment, leading to lower disposable income for the consumer. Thus, the cost of borrowing money from lenders is now higher.
A rise in the Fed rate will also have an impact on the US inflation rate. Inflation represents the rise in the prices of goods and services over time. As we mentioned earlier, higher interest rates will increase the cost of borrowing which will leave consumers with less disposable income to spend on other goods and services. Therefore there will be less demand for these goods and services.
This means there will be less money circulating around the economy and the inflation will decrease. In fact, the Federal Reserve Funds uses the Fed rate to control inflation when it increases a lot. With historically low interest rates during the pandemic, inflation increased. Now, the Federal Reserve needs to make up for that inflation by increasing the target interest rate.
Real Estate Market
The real estate market may also be impacted by a rise in the Fed rate. An increase in the Fed rate means that it will be more expensive to finance the purchase of a house through a mortgage. This is because the mortgage rates will be higher, leading to borrowers facing higher monthly mortgage payments and paying more in interest overall when taking out a mortgage.
Therefore, since it is more expensive to borrow, fewer people will be able to afford it. This means that there will be less demand for housing. Interest rates and the housing market demand have an inverse relationship. When interest rates drop and it becomes cheaper to own a house, the demand for housing increases. On the other hand, housing demand decreases when interest rates increase and the cost of borrowing increases. Therefore, when the Fed rate is increased in 2022, we can expect a stop or slower growth in the real estate market in the U.S.
When interest rates rise, it is not only the consumers who slow down on their spending, but businesses slow down as well. If businesses cut back on their spending, then their earnings and stock prices start dropping. Similarly, when interest rates drop, the spending of businesses increases which later leads to higher earnings and an increase in stock prices.
The bond market is also affected by an increase in interest rates. Typically, when interest rates increase, bond prices fall. Vice versa, when interest rates fall, there is an increase in bond prices. This can also be explained by the increased cost of borrowing caused by the rise in interest rates. Since it is more expensive to borrow money, the demand for low-yield bonds drops which causes their prices to fall.
In conclusion, an increase in the Fed funds rate will have a number of implications on the economy. Starting from the increased cost of borrowing and decrease in consumer and businesses’ spending, to a drop in inflation, stock prices, bond prices and a potential stop in the growth of the real estate market, interest rates have a direct impact on our everyday lives and the bigger economy.
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