Download How Higher Interest Rates Affect the Economy

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Like the prime, other interest
rates are linked to the federal
funds rate – but not always as
tightly. Factors like the level of
government borrowing and
future inflation expectations can
affect the direction of long-term
interest rates.
But if demand continues
to dwindle, many
companies cut back
production and lay off
workers. The resulting
downturn in household
incomes, consumer
confidence and the
value of homes and
other assets compounds
the slowing of economic
activity.
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With Uncle Sam retiring
debt and prices
remaining stable for
most goods and
services, interest
rates on long-term
debt instruments
have stayed
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customers – by an identical
amount, pushing the prime to its
highest level in five years.
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For example, when the Fed raised
its benchmark funds rate by a
quarter point to six percent in
March 2000, banks increased the
prime rate – the price of borrowing
for their most creditworthy
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The Fed engineers changes in the
economy by buying and selling
government securities in its
portfolio to manipulate the federal
funds rate – the interest rate banks
charge each other
for overnight
loans. When
the federal funds
rate rises, other
interest rates tend to
follow as lenders
seek out the highest
returns.
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different groups in different ways.
Monetary adjustments operate with a
“lag” because household spending and business
investment don’t react quickly to
higher rates – for example, some
purchases are locked in by contracts. Businesses often respond
slowly to a drop in demand, so
their inventories tend to accumulate in the short run.
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and investment. But the impacts of rising interest rates affect
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forcing consumers and businesses to cut back on spending
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Typically, higher borrowing costs slow the economy by
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since June 1999 in an effort to rein in economic growth.
It can take as long as a year for
higher rates to work their way
through the economy and affect
decisions by businesses and
consumers. In fact, the economy
actually sped up and grew at
an annual rate of over six
percent since the Fed
started raising interest
rates in June 1999.
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the Federal Reserve has raised interest rates five times
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laiming that inflationary pressures may be building,
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C
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How Higher
Interest Rates
Affect the
Economy
relatively low despite the Fed’s
recent tightening.
The lagged effects of monetary
adjustments make it hard to
predict the eventual outcome of
the Fed’s current tightening. But
the central bank’s last round of
sustained rate hikes may
provide a clue.
By the second quarter of 1995, the delayed impact of seven consecutive rate hikes slowed
economic growth to less than one percent on an annual basis. Per capita income actually shrank.
By March of this year, the Fed raised its benchmark interest rate to the same level as its 1995 peak.
If the central bank continues to tighten as expected, the economy could grind to a standstill again.
Redistribution & Debt
Despite the longest expansion in U.S. history, most
Americans have realized little or no increase in their
net worth. But more Americans are carrying heavy
debt loads. According to the Federal Reserve’s
Survey of Consumer Finances, the portion of families
whose debt payments exceeded 40 percent of their
income grew from 10.5 percent to 12.7 percent
between 1995 and 1998. When the economy
slows, bankruptcies could rise sharply.
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According to economist Willem Thorbecke,
unemployment for African-Americans and Hispanics increased by 9.5 and 8.1 percentage points,
respectively, while white unemployment increased
by only 4.5 percentage points during the Fed’s
tightening of 1979-1982. In the event of a future
downturn, African-American teenagers and
former welfare recipients hired and
trained as a result of today’s tight labor
markets will be laid off first.
Higher rates redistribute money from debtors to
lenders. Some of this redistribution occurs as a
result of costlier credit transactions – creditors reap
the gains as borrowing becomes more expensive
for government, households and businesses. In
addition, some redistribution occurs as a result of
job loss in a slowing economy. In a 1978 study,
economists Alan Blinder and Howard Esaki found
that each one-percent rise in unemployment
transfers 0.28 percent of
national income (approximately $27 billion
in today’s economy)
from the poorest 40
percent of the
population to the
richest 20 percent.
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Rising interest rates impact some businesses more
than others. Interest rate-sensitive industries
include construction, automobiles, and capital
goods. Small firms also tend to be hit harder than
large firms, which can cushion the blow of rising
rates by financing investment internally. Furthermore, low-wage workers and minorities
are much more likely to
lose their jobs during
Fed-engineered
economic slowdowns.
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FINANCIAL MARKETS CENTER
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Housing
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Even though it wields enormous
influence over the economy, the
Fed’s interest rate-setting authority isn’t
as potent as it once was. In large measure
that’s because nonbank financial firms
control a growing portion of money and
credit while the banking industry – the
Fed’s main channel for implementing
monetary policy – accounts for a shrinking
share. With its direct influence over the
supply of money and credit weakened, the
Fed must hammer financial markets with
bigger, more abrupt interest rate changes to
alter borrowers’ demand for credit. One of
the results is growing market volatility.
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Jobs
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The National Association of Home Builders (NAHB)
estimates that 5.6 million households are priced
out of a $150,000 home and 4.5 million households are priced out of a
$75,000 home when 30year fixed mortgage
rates rise from
eight percent to
nine percent.
Even though interest rates remained comparatively low in nominal terms during the last years of the
1990s, inflation-adjusted or real rates ranged much higher than they did during periods of comparable
price stability in the 1950s and 1960s. Indeed, the 1980s and 1990s witnessed the highest sustained
real interest rates of any decade since the 1920s. As households borrowed unprecedented amounts
at high real rates to compensate for
stagnant wages, economic inequality
ballooned – and persists today.
REAL FEDERAL FUNDS RATE
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8.00
6.00
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0.00
Lenders adjust interest rates on Stafford Loans annually
on the basis of Treasury bill yields. A student who takes
out an average-sized Stafford Loan each of his or her
four years in college will graduate approximately
$14,000 in debt. If the loan rates rise by the
expected 1.25 percentage points in July,
students will pay an extra $172 per year in
interest in the first year of repaying a tenyear loan.
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Student Loans
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Interest rates on new car loans
from commercial banks rose from
8.30 in June 1999 to 8.88 in February
2000. Rates on new car loans from auto
finance companies shot up even faster – from 6.56
to 7.34 during the same period. Since the average
car loan clocks in around $20,000, this increase
provides lenders an extra $106-$142 in interest
payments during the first year of a four-year loan.
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During the past decade,
credit card debt tripled.
According to a Federal
Reserve survey, the
median household with
outstanding credit card balances owed an average of
$1600 in 1998 (other estimates are substantially
higher). If the Fed continues to push rates up, credit
card rates will eventually follow. For example, a 75
basis point hike would translate into $110 in additional
annual interest payments for cardholders with an
average outstanding balance (a basis point equals one
one-hundredth of a percentage point).
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Credit Cards
Car Loans
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NAHB also estimates that higher
interest rates will cause new home
production to fall by approximately
80,000 units in 2000. As usual, contractors and
construction workers will feel the heat of higher
interest rates before their counterparts in most
other sectors.
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Interest rates on 30-year conventional mortgages have risen from
7.10 percent in May 1999 to 8.52
percent in May 2000. This surge
translates into additional interest
payments of $1,780 in the first year
of the loan for families purchasing a
home at the median price of
$139,000 with a ten-percent
downpayment.
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