The Federal Open Market Committee (FOMC) of the Federal Reserve meets on a regular basis to decide on short-term interest rates. An increase in interest rates can have both positive and negative effects on consumers’ budgets. For a saver, it is pleasing, but for a borrower, it’s distressing.
In a broad sense, the Fed lowers interest rates in order to stimulate growth in economic activities. As interest rates are essentially the cost of money, a relatively lower rate reduces the cost of borrowing for consumers. Consequently, consumers have greater access to funds and as a result increase their spending, which stimulates the economy.
The Keynesian economic theory refers to two conflicting economic forces that can be influenced by change in interest rates — the marginal propensity to consume (MPC) and the marginal propensity to save (MPS).
Here are some of the most significant ways in which interest rate hikes/cuts usually impact an average consumer.
The direct impact on consumers’ pockets is often the change in spending habits that is strongly correlated to an increase or decrease in rates. It should be noted that a change in interest rates can have different effects on consumer spending habits, depending on a number of factors. These include current rate levels, expected future rate changes, consumer confidence and the overall health of the economy.
It is possible for interest rate changes, either upward or downward, to impact consumer spending and saving. But, the ultimate determinant of the overall effect of interest rate changes primarily depends on the consensus attitude of consumers as to whether they are better off spending or saving in view of the change.
In a low interest rate environment, people are more willing to spend money on big purchases such as cars or homes. When consumers pay less interest, they have more disposable income. This creates a ripple effect of increased spending across the economy.
Conversely, higher interest rates mean that consumers do not have much disposable income and are likely to cut back on spending. Higher interest rates are often accompanied by an increase in lending standards at banks, which end up in fewer loans. An increase in interest rates may lead consumers to save more as they can receive higher rates of return.
The current level of rates and future rate expectations often determine consumer decisions. For example, if the rate falls from 8% to 7% and further declines are expected, consumers may put major purchases on hold until rates are lowered. If rates are already at very low levels, they are usually influenced to spend more to take advantage of good financing terms.
Economic conditions also impact consumer reaction to interest rate changes. Even with attractive low rates, consumers may not be able to take advantage of financing in a depressed economy. Consumer confidence about the economy and future income prospects also determine the extent to which they are willing to increase spending and financing obligations.
Inflation & Recession
When the Fed intervenes to adjust interest rates, it is ideally done to avoid either inflation or recession. Too little money in the market may lead to a recession as spending is severely curtailed by businesses and consumers. On the contrary, increase in money supply lowers its value.
When interest rates fluctuate, the Fed alters the federal funds rate, which is used by commercial banks to lend money to each other. As a result, movement in the federal funds rate affects all other loans. If inflation indicators like the Consumer Price Index (CPI) and the Producer Price Index (PPI) rise more than 2-3% a year, the federal funds rate is raised to check rising prices. Consequently, people start to spend less because higher interest rates mean higher borrowing costs. The demand for goods and services eventually drops, which lowers inflation.
Stock & Bond Markets
The federal funds rate determines how investors park their money. Returns on both certificates of deposit and Treasury bonds are directly affected by this rate. In a rising rate environment, businesses and consumers cut back on their spending, which results in earnings dilution and stock price decline. On the contrary, when interest rates fall significantly, consumers and businesses increase spending, causing stock prices to rise.
There is an inverse relationship between bond prices and interest rates. A rise in interest rates is associated with a decline in bond prices and vice versa. A rise in interest rates moves the cost of borrowing upward and the demand for lower-yield bonds downward. As interest rates fall, it becomes easier to borrow money. More businesses issue new bonds to finance expansion and the demand for higher-yield bonds increases.
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