What Rising Interest Rates Mean for Main Street
As the economy improves, the Fed plans to steadily increase rates to maintain sustainable growth.
The days of crisis-era interest rates are coming to an end. The Federal Reserve announced in December that it was raising the Federal Funds Rate ¼ of a percentage point to a range between 1.25 – 1.50 percent, and expects three more ¼ point raises in 2018.
While the Fed sees these actions as a vote of confidence in the U.S. economy, a rising interest rate environment affects different parts of the economy in unique ways. It is especially important for America’s small businesses and consumers to understand what rising interest rates will mean for them.
Fed mandated to maximize employment, maintain stable prices
The Federal Reserve is tasked with maximizing employment and maintaining stable prices, objectives that are frequently referred to as the “dual mandate.” The Fed’s primary tool for achieving these objectives is the federal funds rate, which is the interest rate that banks borrow from each other overnight; and is the main proxy by which other short-term interest rates are based. When the Fed wants to stimulate economic growth, it lowers the federal funds rate; when the Fed wants to prevent the economy from growing too fast, it raises it.
In the aftermath of the financial crisis, the Federal Reserve lowered the federal funds rate to near zero and has kept rates very low for nearly 10 years. Now that economic growth is improving and the labor market is strong, the Fed wants to steadily increase rates in an effort to maintain sustainable growth.
Rising rates impact businesses and consumers
While increasing the federal funds rate may be in the best interest of the economy as a whole, it can pose some challenges for small businesses and consumers. The prime rate, which is used as a baseline for many shorter-term credit options, moves in tandem with changes to the federal funds rate. As the federal funds rate increases, loans that are based off the prime rate, such as, home equity loans, small business loans, auto loans, and credit card interest rates often become more expensive.
Businesses and consumers may also find themselves spending more of their income paying off existing debt. However, not all of this is negative, as it encourages businesses and consumers to evaluate their financial position and make positive changes.
While it may become more expensive to borrow as interest rates rise, it also becomes more advantageous to save. One of the criticisms of the Fed’s policy to keep rates so low, for so long was that it hurt retirees and other savers who rely on interest-bearing savings accounts and CD’s for income.
As rates rise, these groups should see their savings earn more and will be less likely to risk their money in more speculative assets in order to pay the bills. Another benefit to consumers, and businesses that buy internationally, is that as interest rates rise, the dollar typically rises as well. This makes things like travel and purchasing goods from abroad more affordable.
As with most of the Fed’s actions there are trade-offs, and with rising interest rates on the horizon, it is best to be prepared for the changes to come.