3 Ways Interest Rate Increases and Decreases Affect Consumers

With the American economy finally appearing to pick up some sustained steam in December 2015, the Fed raised interest rates in the United States for the first time since 2006. Although it was just 25 basis points, it was a move that was seen as a sign of confidence in the American economy. What are some of the ways that interest rate increases and decreases affect the average consumer?

Consumer Spending Habits
The most direct impact on consumers is often the change in spending habits that are associated with increases or decreases in the interest rate. Investopedia notes that the first question many consumers face when interest rates change is: do I spend or save? Interest exists in the first place to allow borrowers to spend money immediately, rather than waiting to save up money to make a purchase. With lower interest rates, more people are willing to spend more money to make big purchases on items such as cars or homes.

When consumers are paying less interest it gives them more money to spend overall, and creates a ripple effect of increased spending across the broader economy. Conversely, higher interest rates mean that consumers will not have as much disposable income to work with and will likely cut back on spending. Higher interest rates are often coupled with increased lending standards at banks, which end up making fewer loans.

Inflations and Recessions
When the Fed intervenes to set interest rates, it is usually done to avoid either inflation or a recession. Too little money in the market can mean a recession is likely to occur as spending is severely curtailed by businesses and consumers. Too much money, and the value of money falls through inflation.

When interest rates are rising and falling, the Fed will adjust the federal funds rate which is used by banks to lend money to one another. Movement of federal funds rates affects all other loans as a result, and as such is used as an indicator of rising and falling interest rates. If inflation indicators such as the consumer price index and producer price index rise more than 2-3% in a given year, federal funds rates are usually raised to keep rising prices under control.

As a result, people start spending less because higher interest rates mean higher borrowing costs. The demand for goods and services will drop, and inflation will fall.

Stock Market and Bond Market
Finally, federal funds rates tend to determine how investors will invest their money. Returns on both CDs and T-bonds are affected by this rate directly. When interest rates are rising, and businesses and consumers cut back on spending, earnings begin to fall and stock prices drop accordingly. The reverse is true if rates fall.

There is an inverse relationship between bond prices and interest rates; meaning that a rise in interest rates is associated with bond prices falling, while interest rate decreases result in a rise in bond prices.

In the end, rising interest rates move 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 will issue new bonds to finance expansion, and the demand for higher-yield bonds will increase as prices go up again.

There are many ways in which interest rate changes can impact consumers, but these three are among the most impactful. For more information on this subject and to see what services we offer, please contact Manhattan Ridge Advisors.