How do high interest rates affect the economy?
Higher interest rates influence the economy in various ways: from containing consumer spending to stalling business growth, to determining the value of a country’s currency and the performance of financial markets. A central bank, such as the European Central Bank, typically raises rates when inflation becomes too high, making it more expensive for commercial banks to borrow money from it. Commercial banks, in turn, pass on this additional cost to consumers and businesses, making it more expensive for them to borrow money as well. This increase in the cost of credit generally dampens consumer confidence, leading to a reduction in spending on goods and services.
Interest rates can also influence the value of a country’s currency. When a country’s official interest rate is increased, its currency will appreciate. This is because the higher interest rate attracts foreign savers’ investments from countries where the yield is lower. This, in turn, creates an increase in demand and value of that particular currency. Political and economic stability, clearly, still has a greater impact on a currency’s value than the interest rate of that country.
Moreover, stock markets may also react to interest rate adjustments, as investors take into account both the effects of reduced lending or a greater impact of these on corporate profits, as well as a reduction in spending throughout the economy.
How interest rates affect spending
Rising interest rates affect spending because the cost of money increases. So, if you have a mortgage, any type of credit card, or existing financing, you may end up paying more for the money originally borrowed. This will inevitably mean that you’ll have less money to spend on goods and services. The opposite is also true: if interest rates go down, you’ll likely have more money in your pocket, which could increase spending. Rate hikes, however, offer you an incentive to save more money, as you’ll receive a higher return on the money held in a bank.
Interest rates and inflation
Interest rates and inflation are closely related. Since interest rates affect the cost of money and inflation affects the cost of savings, an increase in one will result in a decrease in the other. Central banks have the difficult task of finding a good balance between the two: keeping interest rates low to encourage consumer spending while also controlling inflation to ensure that prices of goods and services remain affordable. These monetary authorities often react to high inflation by increasing interest rates.
What happens to bonds when interest rates rise?
An increase in interest rates pushes down the price of existing bonds, while a decrease in rates would generally see an increase in bond prices, especially those with long maturities. This bond revaluation is based on the yield an investor would receive if holding the bond until maturity (yield to maturity). If rates rise, prices of existing bonds tend to fall because investors can earn more on newer bonds with higher coupons, so the price of existing bonds
generally drops, giving investors an incentive to buy those bonds. The opposite is true when rates decline.
In the case of government bonds, expectations of future interest rates can have an even greater impact on bond prices than actual rate movements. This is because when the official rate, set by central banks, is expected to rise or fall in the future, parts of the market will adjust their bond positions to optimize returns, which can see prices move further according to increased demand. For example, if investors expect interest rates to decrease from current levels, demand for long-term bonds tends to increase because these will provide a higher return over time compared to short-term bonds. On the other hand, if markets expect an increase in interest rates, short-term bonds become more attractive as they are less sensitive to interest rate changes. The sensitivity to interest rate changes is defined as duration risk, which is measured in years and considers the characteristics of a bond, such as yield, coupon rate, and maturity.
Current situation
Looking at the US economy, despite the federal funds rate benchmark being set at 5.5% by the Federal Reserve at the end of July 2023, there seems to be no sign of economic slowdown; unemployment data remains at historic lows, while consumption continues to rise. Fed leaders expect that their interest rate decisions will eventually slow this growth. The increase in financing costs resulting from Fed decisions do not immediately affect all consumers. They usually impact those who need access to new financing, such as first-time home buyers. Other dynamics, such as the negotiation of contractual agreements between companies, can slow down the effectiveness of monetary policy.
Generally, the longer rates remain high, the more evidence there will be in real terms of an economic slowdown.
Recently, Christopher J Waller, member of the Board of Governors of the Federal Reserve System, expressed his views on this matter at the Economic Club of New York on March 27, 2024, in an article published on the BIS (Bank for International Settlements) website, stating: “[…] economic production and the labor market show ongoing strength, while progress in reducing inflation has slowed. In light of these signals, I see no rush to take steps to loosen monetary policy. The target range for the federal funds rate is between 5.25% and 5.50% since last July, and I believe this restrictive level is helping to reduce imbalances in the economy and continuing to exert downward pressure on inflation. All indications are that the economy continues to grow at a healthy pace. Although retail sales and some other indicators suggest a weakening of demand in this quarter compared to the second half of last year, when growth accelerated, evidence of a significant slowdown is scarce. Meanwhile, as the labor market continues to add new jobs at a rapid pace, some signs indicate an improvement in the imbalance between supply and demand, while others indicate continuing rigidity. […].”
