I owned a mortgage brokerage when the market collapsed in 2008. I was already familiar with mortgage rates, but this was the first time I saw fed rates fall to the floor. It took 5 years for rates to start climbing again. Now we’re in the same situation. As business owners, if there’s an easy way to increase profits, we want to know about it. Those who understand the effects and advantages of these lowered rates are more able to discover ways to profit from them, so I hope this article helps you to not only understand but to also benefit.
What is the Impact of Interest Rate Changes That Are Done By the Federal Reserve?
Many people are aware that the Federal Reserve, known as the Fed, tends to cut interest rates when the economy begins to struggle and raises the interest rates when the economy is flourishing, but one might wonder what the reasoning behind this is. In theory, when rates are decreased so are the borrowing costs, so this should prompt businesses to take out loans to hire more people while also expanding production. Contrastingly, the opposite effect takes place when there is a booming economy. As a result, the change in interest rates has very real effects on businesses and consumers, so we will help you learn more about this by presenting the information below.
Interest Rates and Borrowing
Bond prices and interest rates have an inverse relationship, so as interest rates rise the prices of bonds fall, which has a negative impact on fixed-income investors. In addition to this, when the rates rise people are less likely to borrow or refinance existing debts due to the fact that it is more expensive for them to do so at times like that. However, when there are lower interest rates, yields on everything, including treasuries and corporate bonds, tend to fall and new investors are less attracted to them.
The Prime Rate
The prime rate is the credit rate that banks give to their most credit-worthy customers, and other forms of consumer credit are based on the prime rate. When the rate is higher, banks will increase both fixed and variable rate borrowing costs when they assess risk on their less credit-worthy clients. It is important to note that changes in the Fed’s rate have an effect on the prime rates. An increase in the Fed rate increases the prime rate.
Another effect of the prime rate is the fact that with its increase, the money market and certificate of deposit rates also increase. The theory behind this is that this should increase savings among both consumers and businesses as a higher return can be generated on saving during these times. That being said, the people that have debt that needs to be paid will tend to try to pay off the obligations in order to offset the higher variable rates.
When there is an increase in interest rates there is a corresponding increase in the borrowing costs for the US government, which in turn increases the national debt.
The Effect on Business Profits
Banking sector profits from the increase in interest rates since they earn more money on the dollars that they lend out. For everyone else in the business sector, however, the increase in interest rates deters profits. This is so because the cost of capital required to expand the business increases. When interest rates are lowered, on the other hand, businesses tend to see a boost in their profits since it is cheaper to finance capital, and investments in operations can be made at a lower cost.
The auto business is also impacted by interest rate changes. When there are lower interest rates on auto loans, there should be more car purchases, as such resulting in more profits. As such auto companies benefit from cuts in interest rates.
Another sector that is largely impacted by interest rates is home buying. Mortgage rates tend to fluctuate in sequence with domestic 10-year Treasury bonds, which are in turn, are greatly affected by interest rates. As a result, when interest rates increase, mortgage rates will also increase, making it more expensive to buy a home. When there is an expectation for rates to increase many homebuyers tend to hurry and fix the rate on their homes to keep the lower rate. Similarly, when there are higher interest rates and higher inflation, the demand in the housing sector drops.
There is also a decrease in consumer impulse buying when there are higher credit card rates and higher savings rates because a rise in the borrowing costs tends to play a big factor in the consumers’ spending decisions. That being said, when the interest rates are decreased, the consumer can buy things such as appliances, cars, regular goods, etc, on credit at a lower cost.
When the interest rates are high, the consumers’ disposable income is lowered. This is so because as the interest rates rise, they must pay more interest to lenders, creating a negative effect on their spending habits as they need to pay more money towards their debts, causing less disposable income to be available to spend on other things. This means that consumers spend less of their money on businesses that sell luxury items and services, and tend to lean towards businesses that provide the basic staples.
The higher interest rates also mean that loans become more expensive when interest rates rise. Usually, long-term debts take many years to be paid off, so an increase in the interest rates makes the businesses carry the debt even longer, while also paying more money. Moreover, the higher interest rates also make it harder for businesses to take out short-term loans that can be used to help finance unexpected expenses on business expansion, which in turn short-circuits the company’s growth and can leave a lasting imprint.
What is the Interest Rates’ Effect on Inflation?
Inflation can be caused by multiple factors, including a nation’s currency losing value or by the nation’s economy booming so much that the demand for goods is much larger than the supply causing prices to increase immensely. Overall inflation happens when the prices of goods and services rise in the economy. Even though inflation is a result of a strong, healthy economy it can lead to the loss of purchasing power if left uncontrolled. When inflation increases it is an often occurrence for interest rates to increase as well in order for the central bank to try to keep the inflation in control. If interest rates fall, inflation will be accelerated because people will start to buy things on cheap credit causing an uptick in prices again.
The federal funds rate is often brought up when interest rates change, and this is the rate that banks use to lend each other money. This rate can change daily, and it affects all other loan rates, so it is often used as an indicator to show if interest rates are rising or falling.
Interest Rates and the Stock & Bond Market
Even though the increase in interest rates tends to decrease profitability overall, the companies that do most of their businesses within the United States tend to see the rise as a good thing. This is so because of the fact that the U.S. dollar is seen as being stronger, and local products become more attractive. For those businesses that do a lot of international business this is a negative effect because as the US dollar rises, strengthened by the increased interest rates, the companies abroad start to see a minimization in sales.
Despite this fact, the financial sector finds the increase in interest rates to be beneficial. During these increases, bank stocks have a tendency to perform well. Generally, interest rates and the stock market tend to move in opposite directions, meaning that when the Fed increases interest rate the stock market as a whole tends to go down and vice versa. Earnings will fall and stock prices will drop when there is an increase in interest rates as it affects consumer and business psychology causing them to cut back on spending. However, it is important to keep in mind that there is no guarantee as to how exactly the market will actually react to the changes that the Fed makes to the interest rates.
Interest rates also have an effect on bond prices in an inverse relationship. When interest rates rise, bond prices fall, and in addition to this, it is important to note that the longer the maturity of the bond the greater the fluctuation will be in terms of interest rate correlation. Through the sales of bonds businesses and the government are able to raise money. As alluded to previously, the cost of borrowing becomes more expensive when interest rates increase, which results in a decrease for lower-yield bonds, which in turn causes their price to drop. The opposite happens when interest rates fall, and many companies issue new bonds in order to finance expansion. Bond prices will also increase as the demand for higher-yielding bonds increases. Those who issue callable bonds can also choose to refinance by calling the bonds they have in order to lock in the lower interest rate.
Changing Interest Rates and Their Impact on Businesses
It is evident that changing interest rates have major effects on all aspects of the economy and the lives of both consumers and businesses. It is important to understand these correlations in order to know what to expect and to be prepared to face the changes and challenges.