The Eclectic Economist

The Eclectic Economist

Fed interest rate hike may have less of an impact than you think

For everyone, there are things to like and not like in higher interest rates. Thumbs via www.shutterstock.com

There is a very high chance the Federal Reserve will raise interest rates next week.

It would be the first time the Federal Open Monetary Committee (FOMC) – the Fed’s rate-setting team – has lifted its benchmark rate since 2006, beginning the so-called return to normal.

Economists, traders and policymakers have been pontificating, prognosticating and placing bets about this decision for a long time, because the impact is expected to be far-reaching.

So how will higher rates affect you?

Depending on your situation, an increase in rates could be wonderful news, a disaster or another headline story that after the initial excitement has no impact on your life.

Whether you save, travel, want to buy a house or invest in stocks, a rate hike will almost certainly affect you in one way or another – though perhaps not as much as some commentators will make you think.

Who gains when rates go up

If you have a lot of money in savings accounts, certificates of deposit (CD) or money market accounts, higher rates are wonderful news.

Many retirees in the US live off their Social Security checks plus interest and dividends from their savings. When interest rates rise, retirees and people with large amounts of cash savings earn more money. This enables them to spend more.

Even if you don’t have a single penny in savings but live or work in an area with a large number of retirees such as southern Florida, Arizona or parts of California, the interest rate increase means more jobs and an overall better economic situation.

Another group of people who will love higher interest rates are people planning on traveling abroad for vacation. Interest rate changes often have an impact on a country’s foreign exchange rate. When interest rates rise in the US, the dollar often buys more foreign currency. This makes traveling to other parts of the world much cheaper.

The reason interest rate changes affect foreign exchange rates is that people around the world have saved money. When US interest rates rise, people living outside the country want to put their money in US banks and money market accounts to get the higher rates.

To do this, they need to sell their local currency and buy dollars before making a deposit. This results in the price of dollars going up and the price of other currencies going down. US tourists will find when visiting other countries that each US dollar buys more hotel rooms, food, museum admissions and other attractions, making travel after the rate hike much more pleasant.

The change in foreign exchange rates also makes people who sell goods to the US much happier. Japanese cars, French wines, Chinese televisions, Brazilian coffee and many other items will become cheaper for people in the US. This reduction in price causes people in the US to buy more products from abroad, which will boost employment in countries selling these items.

Selling a house will be somewhat harder if rates go up next week as expected. House sold via www.shutterstock.com

Who loses

If you owe money on your credit cards, then higher rates are a disaster because you will shortly be forced to pay more money every month.

In 2010, US credit card issuers had to follow new rules in the “CARD Act.” One of the key provisions of this act was to give people at least 45 days before their interest rate changed.

However, the CARD act’s section 171(b)(2) contains a loophole that enables interest rates to go up much faster. If the credit card company determines the holder’s interest rate by adding a fixed percentage on top of a widely available index, like the “prime rate,” then there is no need for a 45-day notice.

How long will it take your credit card company to start charging you more money? For the average person it will take about two weeks.

I just received a notice from my credit card company to remind me that the interest I pay on any balances “will vary with the market” and that if interest rates rise, “any new rate will be applied as of the first day of your billing cycle.”

This means for me and many other credit card holders that the shortest time frame to begin paying more is just a few days after the Fed makes its decision and the longest time is 45 days, for people whose banks need to send out a fee hike notice. Either way, people with credit card balances are affected very quickly.

Almost everyone associated with residential real estate is not happy that interest rates are rising. Home builders, furniture makers, appliance salesmen and others will likely see a drop in sales as rising rates make purchasing a new home more expensive, because borrowing money to pay for the new home costs more. Additionally, people with variable rate mortgages will owe more money each month to pay for their homes, giving them less money to spend.

Stock investors will also be adversely affected, likely through lower returns and prices. My full explanation is found here, but the synopsis is that when interest rates rise, investors value profits earned in the future much less and are not willing to pay as much for outstanding shares of stock, thus causing prices to fall.

The price of stock is important because some people, like retirees, base their spending not only on their Social Security checks but also on the value of their portfolio.

The final groups that will lose out when interest rates rise are people in the US who sell products abroad (exporters) or who deal with foreign tourists.

Exchange rate changes that make imports 10% cheaper make exports 10% more expensive. This means when importers are happy, exporters are miserable. Foreign tourists will find the US a more expensive travel destination. Foreign buyers will find US crops like wheat, corn and soybeans more expensive. Large multinationals, like Boeing, will have a more difficult time selling planes and other expensive capital equipment outside the US.

Boeing’s new 737 Max will likely become more expensive as the Fed begins to raise rates. Reuters

The final score

In general, it is hard to say who wins absolutely because many of us do not fit into a single category. We may win a little and lose a little.

For example, I have money in savings, which will earn more interest, but I also owe money, so it means I’ll have to pay a higher rate. I love traveling outside the US, which will cost me less, and this makes me better off. However, some of my pay comes from teaching, and there has been a surge in foreign students attending US universities over the past 20 years. If foreign students stop coming to the US because it is too expensive, fewer college professors will be needed, which is bad for me.

When the FOMC raises rates, large headlines and talk show hosts will scream that the world has changed with the end of seven years of near-zero interest rates. The hype and coverage will probably be tremendous.

However, an interest rate hike makes different parts of each person’s finances better and worse off. For most of us, thinking seriously about all the effects will result in mixed feelings about any upcoming interest rate hikes.

My guess is that for many readers, the offsetting forces will make this another headline story that, after the initial excitement has worn off, actually has relatively little effect on your life.

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