tag:theconversation.com,2011:/us/topics/borrowing-costs-51197/articlesBorrowing Costs – The Conversation2023-10-06T13:28:15Ztag:theconversation.com,2011:article/2151882023-10-06T13:28:15Z2023-10-06T13:28:15ZUK bonds have hit a 25-year high – here’s what that means for the economy<figure><img src="https://images.theconversation.com/files/552531/original/file-20231006-19-z1l72a.jpg?ixlib=rb-1.1.0&rect=0%2C0%2C4230%2C2811&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">The Bank of England (headquarters on the left) is expected to hold interest rates, causing investors to sell UK bonds.</span> <span class="attribution"><a class="source" href="https://www.shutterstock.com/image-photo/london-november-3-2016-modern-red-509977993">lazyllama/Shutterstock</a></span></figcaption></figure><p>It’s been more than a year since the UK economy was thrown into crisis after then-prime minister Liz Truss suggested making a wealth of <a href="https://theconversation.com/only-a-u-turn-by-the-government-or-the-bank-of-england-will-calm-uk-financial-markets-191523">unfunded tax cuts</a> in her September 2022 mini-budget. But a recent bond market sell-off has now sent borrowing costs rocketing again, pushing the bond market even higher than after Truss’s announcement. </p>
<p>Yields on UK treasury bonds – the rate the UK government must pay to borrow money – have risen to approximately 4.6% for ten-year bonds. Yields on 30-year bonds hit 5.1%, the highest since 1998. </p>
<p>Banks also use this rate as a key benchmark to set commercial loan rates, so this means borrowing costs are rising for businesses, as well as for the government. Two-year and five-year treasury yields (which are used to set mortgage rates) are also above the budget-fuelled high of last year, and at levels not seen in over ten years. </p>
<p><strong>UK bond yields (30 year), 1998-2023:</strong></p>
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<a href="https://images.theconversation.com/files/552545/original/file-20231006-29-k1z29z.png?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="Line chart showing 30-year bond yields hitting highs last seen in 1998." src="https://images.theconversation.com/files/552545/original/file-20231006-29-k1z29z.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/552545/original/file-20231006-29-k1z29z.png?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=297&fit=crop&dpr=1 600w, https://images.theconversation.com/files/552545/original/file-20231006-29-k1z29z.png?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=297&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/552545/original/file-20231006-29-k1z29z.png?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=297&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/552545/original/file-20231006-29-k1z29z.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=373&fit=crop&dpr=1 754w, https://images.theconversation.com/files/552545/original/file-20231006-29-k1z29z.png?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=373&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/552545/original/file-20231006-29-k1z29z.png?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=373&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
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<span class="attribution"><a class="source" href="https://tradingeconomics.com/united-kingdom/30-year-bond-yield">Trading Economics</a>, <a class="license" href="http://creativecommons.org/licenses/by-nd/4.0/">CC BY-ND</a></span>
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<p>The government issues treasury bonds at a particular interest rate that corresponds to a fixed value. Investors buy the bonds and the government uses the money to finance its spending. Since it’s a loan, the government repays the investors but also pays interest on the bond until repayment – this is the yield. </p>
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Read more:
<a href="https://theconversation.com/how-bonds-work-and-why-everyone-is-talking-about-them-right-now-a-finance-expert-explains-191550">How bonds work and why everyone is talking about them right now: a finance expert explains</a>
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<p>For example, a 5% bond issued for a £100 earns the investor £5 interest. If the government issues a later bond at 6% for £100 (£6 interest), the 5% (£5) bond’s value drops. This is why when bond prices fall, the yield rises and vice versa. </p>
<p>Right now, UK treasury yields are rising because investors are trying to sell UK government bonds – falling demand makes the price drop. </p>
<p>And this isn’t just happening in the UK. The same is true <a href="https://www.reuters.com/markets/global-markets-wrapup-1-2023-10-04/">around the world</a>. US bonds, for example, recently hit <a href="https://www.cnbc.com/2023/10/03/us-treasury-yields-investors-weigh-economic-outlook.html">a 16-year high</a>. </p>
<h2>Why is this happening right now?</h2>
<p>This is a tale of two central banks navigating difficult economic conditions. In September, both the Bank of England and the Federal Reserve chose not to increase their main interest rates (which are at 5.25% and 5.5% respectively). The reasons for these decisions and the position of each economy are driving the bond market changes. </p>
<p>In terms of the economy, headline inflation is currently 6.7% (6.2% for core, which strips out more volatile items like energy) <a href="https://www.ons.gov.uk/economy/inflationandpriceindices/bulletins/consumerpriceinflation/august2023">in the UK</a>, and 3.7% (4.3% core) <a href="https://www.bls.gov/news.release/cpi.nr0.htm">in the US</a>. GDP growth is at 0.6% for the UK and 2.4% for US. So, the two economies are on different tracks. </p>
<p>These figures influence financial market expectations about what central banks might do next with interest rates. The divergence in growth rates and inflation between the two economies had signalled that the banks would take different routes at their September meetings.</p>
<p>Prior to the latest decision by the Bank of England, there was <a href="https://www.schroders.com/en-gb/uk/institutional/insights/uk-should-brace-for-6-5-interest-rates-here-s-why-we-ve-raised-our-forecast/">a general view</a> that UK <a href="https://www.reuters.com/markets/rates-bonds/boe-bank-rate-peak-seen-550-strong-chance-575-2023-08-24/">rates would rise</a> to 5.5%, but a lower-than-expected inflation rate was announced days before the bank met to decide on rates and this led them to hold rates instead. After the meeting, the Bank of England also indicated that, while it expected its rate to remain at 5.25% for some time, it did not <a href="https://www.theguardian.com/business/2023/sep/21/bank-of-england-keeps-interest-rates-hold">foresee a further rise</a>. </p>
<p>In contract, while the Federal Reserve also held rates in September, this was <a href="https://www.reuters.com/markets/us/fed-leave-rates-unchanged-sept-20-cut-unlikely-before-q2-2024-2023-09-12/">seen as a pause</a> and not a stop. US rates are widely expected to rise again this year.</p>
<figure class="align-center zoomable">
<a href="https://images.theconversation.com/files/552512/original/file-20231006-19-k0slke.jpeg?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="Chart showing that 12 of the 19 FOMC members anticipate one more 25 basis point hike this year, seven expect no change before end of 2023." src="https://images.theconversation.com/files/552512/original/file-20231006-19-k0slke.jpeg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/552512/original/file-20231006-19-k0slke.jpeg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=600&fit=crop&dpr=1 600w, https://images.theconversation.com/files/552512/original/file-20231006-19-k0slke.jpeg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=600&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/552512/original/file-20231006-19-k0slke.jpeg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=600&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/552512/original/file-20231006-19-k0slke.jpeg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=754&fit=crop&dpr=1 754w, https://images.theconversation.com/files/552512/original/file-20231006-19-k0slke.jpeg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=754&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/552512/original/file-20231006-19-k0slke.jpeg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=754&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
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<span class="caption">Twelve members of the Fed’s 19-person rate-setting committee expect one more 0.25% interest rate hike this year, while 7 FOMC members expect no change before the end of the year.</span>
<span class="attribution"><a class="source" href="https://www.statista.com/chart/29055/fomc-projections-for-the-federal-funds-rate/">Statista</a>, <a class="license" href="http://creativecommons.org/licenses/by-nd/4.0/">CC BY-ND</a></span>
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<h2>What has this got to do with bond yields?</h2>
<p>The expected rise in US rates means investors do not want to hold US bonds whose value will fall as a result. As explained before, when newer bonds are issued at higher yields (to reflect the bank’s most recent interest rate decison), existing bonds (those previously issued with lower yields) will be valued less by investors because they will get less in interest payments for holding them.</p>
<p>This is why investors are selling US bonds. For a related, but slightly different reason, investors also don’t want to hold UK bonds. As US bonds will soon earn a higher yield, investors are selling UK bonds to reposition their portfolios towards the US, where they will be able to earn a higher yield.</p>
<p>This also has implications for the value of the pound. Since the Bank of England’s decision not to raise the interest rate in September, the value of the pound has <a href="https://www.cnbc.com/2023/10/03/sterling-had-its-worst-month-for-a-year-and-it-may-fall-further.html">fallen</a> versus the US dollar. This is because the same investors that are selling UK Treasuries and driving up yields, are also selling pounds to buy US dollars. </p>
<p>The UK is not alone in feeling this effect, the euro is also weakening and against the US dollar, while the Japanese yen is close to the same low that prompted <a href="https://www.reuters.com/markets/asia/japan-likely-spent-record-amount-october-prop-up-yen-2022-10-31/">an intervention by the Bank of Japan</a> around this time last year. </p>
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<img alt="Globe surrounded by currency symbols on different types of bank notes." src="https://images.theconversation.com/files/552529/original/file-20231006-15-r7s87l.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/552529/original/file-20231006-15-r7s87l.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=400&fit=crop&dpr=1 600w, https://images.theconversation.com/files/552529/original/file-20231006-15-r7s87l.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=400&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/552529/original/file-20231006-15-r7s87l.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=400&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/552529/original/file-20231006-15-r7s87l.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=503&fit=crop&dpr=1 754w, https://images.theconversation.com/files/552529/original/file-20231006-15-r7s87l.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=503&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/552529/original/file-20231006-15-r7s87l.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=503&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
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<span class="caption">Global currency markets.</span>
<span class="attribution"><a class="source" href="https://www.shutterstock.com/image-photo/world-on-international-banknotes-currency-sign-2108080049">Dilok Klaisataporn/Shutterstock</a></span>
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<p>In each case, the reason is the same: the strength of the US economy relative to other economies (0.5% GDP growth for the Eurozone and 1.6% for Japan) is attracting more investors. As with the UK, the policy rates for the Eurozone and Japan are below those of the US, with each central bank indicating an intention not to make further increases.</p>
<p>But both of these effects – higher treasury yields and a depreciating pound – spell bad news for the UK economy. </p>
<p>The higher yields imply higher borrowing costs, including interest payments for the government, as well as both mortgages and business loans. The fall in the value of the pound means that imports are more expensive. Together with the fact that many commodities (such as oil) are priced in US dollars, this can contribute to higher inflation. </p>
<p>Since the economy is also barely growing, both issues will continue to have a dampening effect on the UK.</p><img src="https://counter.theconversation.com/content/215188/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>David McMillan does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Rates are now higher than after Liz Truss’s 2022 mini-budget.David McMillan, Professor in Finance, University of StirlingLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/2110922023-08-10T12:42:10Z2023-08-10T12:42:10ZUS losing Fitch’s top AAA credit rating may portend future economic weakness<figure><img src="https://images.theconversation.com/files/541770/original/file-20230808-25-a9fldt.jpg?ixlib=rb-1.1.0&rect=132%2C150%2C6139%2C3131&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Money doesn't grow on trees for governments either.</span> <span class="attribution"><a class="source" href="https://www.gettyimages.com/detail/photo/falling-dollar-bills-from-money-tree-royalty-free-image/157593960?adppopup=true">imagedepotpro/E+ via Getty Images</a></span></figcaption></figure><figure class="align-center zoomable">
<a href="https://images.theconversation.com/files/541789/original/file-20230808-21-ujknkk.png?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="" src="https://images.theconversation.com/files/541789/original/file-20230808-21-ujknkk.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/541789/original/file-20230808-21-ujknkk.png?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=255&fit=crop&dpr=1 600w, https://images.theconversation.com/files/541789/original/file-20230808-21-ujknkk.png?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=255&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/541789/original/file-20230808-21-ujknkk.png?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=255&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/541789/original/file-20230808-21-ujknkk.png?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=321&fit=crop&dpr=1 754w, https://images.theconversation.com/files/541789/original/file-20230808-21-ujknkk.png?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=321&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/541789/original/file-20230808-21-ujknkk.png?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=321&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
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<span class="attribution"><a class="license" href="http://creativecommons.org/licenses/by-nd/4.0/">CC BY-ND</a></span>
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<p>The formerly pristine reputation of the U.S. government’s debt lost a little more luster after another prominent rating agency <a href="https://www.vox.com/2023/8/2/23817311/fitch-downgrades-us-credit-rating">demoted Uncle Sam from its AAA perch</a>.</p>
<p>What does a downgrade of U.S. creditworthiness like this actually mean?</p>
<p>While the downgrade is unlikely to have much of an impact in the short term, its implications about the state and size of U.S. indebtedness will likely reverberate on Capitol Hill, where <a href="https://apnews.com/article/congress-spending-bills-shutdown-aea04e44447fcb8a818a01a54854ac12">stalled negotiations over the budget</a> could mark a step toward the Biden administration’s first government shutdown.</p>
<p>Fitch Ratings’ decision on Aug. 1, 2023, led to small declines in the stock and bond markets. But as an economist who <a href="https://scholar.google.com/citations?user=czu6ChoAAAAJ&hl=en&oi=ao">studies the effects of monetary and fiscal policies</a>, I’ve got longer-term concerns about the downgrade’s implications for U.S. economic growth.</p>
<p>To understand why, you have to look at both the reasons for Fitch’s downgrade and what it means for U.S. borrowing going forward.</p>
<h2>Why Fitch downgraded the US</h2>
<p>Just like people, the federal government has to balance the income it takes in and the money it spends for each fiscal year. Most federal income consists of tax revenue.</p>
<p>Since 2001, <a href="https://fiscaldata.treasury.gov/americas-finance-guide/national-deficit/">that revenue has rarely covered enough</a> of the costs of everything the U.S. government pays for, from roadways to wars. When federal income falls short, the government fills the gap by borrowing money from investors. </p>
<p>That gap has gotten a lot bigger in recent years as the U.S. has spent trillions fighting COVID-19, contending with financial crises and funding several wars. As of Aug. 1, the U.S. Treasury <a href="https://fiscaldata.treasury.gov/datasets/debt-to-the-penny/debt-to-the-penny">owed US$32.6 trillion</a>, both to bondholders and other parts of the federal government. </p>
<p><a href="https://www.fitchratings.com/research/sovereigns/fitch-downgrades-united-states-long-term-ratings-to-aa-from-aaa-outlook-stable-01-08-2023">That’s part of the reason</a> that Fitch cut the U.S. government’s long-term creditworthiness by one notch, from AAA – its highest rating – to AA+. Fitch also cited an “erosion of governance,” specifically pointing to <a href="https://theconversation.com/political-compromises-like-the-debt-limit-deal-have-never-been-substitutes-for-lasting-solutions-206964">recent efforts by conservatives</a> to prevent the U.S. from raising its debt ceiling. </p>
<h2>What happened last time</h2>
<p>This was not the first time that a rating agency lowered the credit of the U.S. government. </p>
<p>In 2011, Standard & Poor’s, one of Fitch’s competitors, also <a href="https://www.cnn.com/2023/08/02/investing/premarket-stocks-trading/index.html">downgraded its rating for the U.S.</a> from AAA to AA+. S&P <a href="https://www.washingtonpost.com/business/economy/sandp-considering-first-downgrade-of-us-credit-rating/2011/08/05/gIQAqKeIxI_story.html">similarly blamed governance issues</a> – that downgrade followed a similar debt ceiling standoff – as well as the burden of rising government debt. </p>
<p>At the time, Fitch issued a warning but it didn’t cut the U.S.’s credit rating until now.</p>
<p>The 2011 episode had <a href="https://www.wsj.com/articles/SB10001424127887323984704578203593473607014">no long-term effects on financial markets</a>, including Treasury bonds – meaning investors remained happy to continue lending to the U.S. at favorable rates.</p>
<p>Does that mean Fitch’s downgrade will similarly have little long-term impact? Not necessarily.</p>
<h2>Why things might be different</h2>
<p>Any country seeking to borrow money in perpetuity needs lenders who are happy to lend.</p>
<p>For the U.S., that means it needs a constant supply of <a href="https://theconversation.com/why-the-national-debt-doesnt-matter-or-how-i-learned-to-stop-worrying-and-love-treasuries-38775">buyers for Treasury bonds</a> and the other securities it sells. These <a href="https://www.treasurydirect.gov/auctions/">securities are sold in auctions</a> and then traded on global financial markets.</p>
<p>Investors of all kinds around the world find Treasurys attractive. They’re <a href="https://www.investopedia.com/ask/answers/042215/what-are-risks-associated-investing-treasury-bond.asp">seen as safe</a>, because the U.S. government is considered less likely to default than, say, a company going bankrupt.</p>
<p><a href="https://www.fitchratings.com/">Rating agencies like Fitch</a> assess these risks and periodically adjust their credit rating scores based on their assessment on the ability of the federal government – and other borrowers – to keep up with their debt obligations.</p>
<p>“Repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management,” Fitch said in its announcement, in a reference to recurring <a href="https://theconversation.com/political-compromises-like-the-debt-limit-deal-have-never-been-substitutes-for-lasting-solutions-206964">fights among lawmakers over raising the debt ceiling</a>.</p>
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<a href="https://images.theconversation.com/files/541773/original/file-20230808-27-no5i2r.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="American flag design on a cracked background, worn and torn." src="https://images.theconversation.com/files/541773/original/file-20230808-27-no5i2r.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/541773/original/file-20230808-27-no5i2r.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=399&fit=crop&dpr=1 600w, https://images.theconversation.com/files/541773/original/file-20230808-27-no5i2r.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=399&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/541773/original/file-20230808-27-no5i2r.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=399&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/541773/original/file-20230808-27-no5i2r.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=501&fit=crop&dpr=1 754w, https://images.theconversation.com/files/541773/original/file-20230808-27-no5i2r.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=501&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/541773/original/file-20230808-27-no5i2r.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=501&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
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<span class="caption">Rifts between Republicans and Democrats are making it harder for Congress to pass budgets and get other important work done.</span>
<span class="attribution"><a class="source" href="https://www.gettyimages.com/detail/photo/concept-american-flag-on-cracked-background-royalty-free-image/607610082?phrase=flag+fractured&adppopup=true">Delpixart/iStock via Getty Images Plus</a></span>
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<p>But if economists and financial analysts deem Treasurys to be growing riskier, then investors may become less interested in buying them. Alternatively, they may demand a higher interest rate in exchange for taking on the risk that the U.S. may default on its debts.</p>
<p>So, however the market reacts, I believe that this downgrade reflects the real deterioration of America’s fiscal standing as well as its ability to safeguard it. </p>
<p>And as economists and financial analysts decide Treasurys are becoming a riskier security to hold – whether because of the size of overall U.S. debt or because <a href="https://theconversation.com/why-america-has-a-debt-ceiling-5-questions-answered-164977">political brinkmanship</a> is making a once-unthinkinkable default more likely – then investors may become less interested in buying them. Or, at least, they may demand the U.S. pay them more to take on the risk, resulting in higher borrowing costs for the government.</p>
<p>Ultimately, this means there will be less money for everything else the U.S. might want to spend money on – or the overall debt load will rise even faster.</p>
<h2>Limited options</h2>
<p>To cover its growing borrowing costs, the federal government has few options – none good.</p>
<p>It can borrow more money, which is seen as riskier – like taking out one loan to pay off another – and could result in an even lower credit rating and a continuous spiral of rising borrowing costs. Or it could hike tax rates or cut spending, both of which have political consequences and could be hard to accomplish given the <a href="https://www.pewresearch.org/short-reads/2022/03/10/the-polarization-in-todays-congress-has-roots-that-go-back-decades/">degree of polarization in Congress</a>.</p>
<p>Furthermore, <a href="https://doi.org/10.1111/rode.12661">research has shown that higher government debt</a> is generally associated with lower long-term economic growth, which reinforces the problem by reducing revenue and thus requiring more debt. </p>
<p>So, while Fitch’s downgrade doesn’t signal an imminent financial crisis, it does serve as a warning as Congress engages in its fiscal fights – including the <a href="https://apnews.com/article/congress-spending-bills-shutdown-aea04e44447fcb8a818a01a54854ac12">one over the budget</a> that will heat up in September.</p><img src="https://counter.theconversation.com/content/211092/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Hakan Yilmazkuday does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>The rating agency demoted the US government’s creditworthiness to AA+, its second-highest ranking, on Aug. 1, 2023.Hakan Yilmazkuday, Professor of Economics, Florida International UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1990572023-02-01T21:51:00Z2023-02-01T21:51:00ZWhy the Fed raised interest rates by the smallest amount since it began its epic inflation fight<figure><img src="https://images.theconversation.com/files/507713/original/file-20230201-11673-evozko.jpeg?ixlib=rb-1.1.0&rect=495%2C107%2C6242%2C4596&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Markets reacted positively to Fed Chair Powell's acknowledging “disinflation” is happening. </span> <span class="attribution"><a class="source" href="https://newsroom.ap.org/detail/FinancialMarketsWallStreet/48a40a8b04be49a3b4dfa080df418c52/photo?Query=federal%20reserve&mediaType=photo&sortBy=arrivaldatetime:desc&dateRange=now-24h&totalCount=30&currentItemNo=9">AP Photo/Seth Wenig</a></span></figcaption></figure><p><em>The Federal Reserve’s policy-setting committee <a href="https://www.federalreserve.gov/newsevents/pressreleases/monetary20230201a.htm">lifted interest rates</a> on Feb. 1, 2023, by a quarter of a percentage point to a range of 4.5% to 4.75%. The increase, <a href="https://www.federalreserve.gov/monetarypolicy/openmarket.htm">the smallest</a> since the Fed began an aggressive campaign of rate hikes in March 2022, came amid signs the fastest pace of inflation in decades <a href="https://www.nytimes.com/2023/01/30/business/economy/inflation-rate-fed.html">is cooling</a>. But the Fed also indicated more rate hikes are coming.</em></p>
<p><em>So why is the Fed slowing the size of rate increases now, and what does it mean for consumers? We asked finance scholar <a href="https://scholar.google.com/citations?user=eP0xZ1kAAAAJ&hl=en&oi=ao">William Chittenden</a> from Texas State University to explain what’s going on and what comes next.</em> </p>
<h2>Why did the Fed raise rates by only a quarter point?</h2>
<p>The Fed is trying to figure out whether last year’s rate hikes have slowed the economy enough to get inflation near its target of about 2%. </p>
<p>By raising what’s known as the Fed funds rate, the U.S. central bank makes borrowing more expensive, which means buying large-ticket items, like cars and homes, is more costly. This should lead to fewer people buying cars, which will likely result in lower car prices. </p>
<p>In 2022, the Fed lifted rates eight times by a total of 4.25 percentage points, which helped prompt inflation to drop to an annual pace of <a href="https://www.usinflationcalculator.com/inflation/historical-inflation-rates/">6.5% in December from 9.1% at its peak in June</a>. </p>
<p>To understand why it’s so hard for the Fed to figure out if its rate hikes worked, think of the economy as a fully loaded oil tanker out in the ocean. Naturally, it’s chugging along as fast it can to reach a specific destination, but it takes a long time from the captain “stepping on the brakes” to when the ship actually stops moving forward. </p>
<p>Similarly, the Fed is raising rates to slow the economy – sort of like stepping on the brakes – and bring inflation down to 2%, but there’s often a <a href="https://www.wsj.com/livecoverage/federal-reserve-meeting-interest-rate-hike-february-2023/card/debate-over-policy-lags-could-shape-future-rate-decisions-jSHal2idzCac4x5bcJ3s?mod=Searchresults_pos1&page=1">long delay between the hikes and their impact on the economy</a>.</p>
<p>But if the Fed eases off the brakes too early, inflation could remain high. If it presses on them too hard, unemployment will likely shoot up and the economy will slide into a recession. By increasing interest rates only a quarter-point, the Fed is signaling that it believes the economy has begun to slow down and is on a path to 2% inflation.</p>
<h2>Does this mean borrowing costs will start coming down?</h2>
<p><a href="https://www.bankrate.com/rates/interest-rates/prime-rate/">The Fed funds rate acts as a base rate</a> for shorter-term interest rates, such as for car loans and credit cards. As it goes up, short-term borrowing rates increase by about the same amount. </p>
<p>The financial markets <a href="https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html">are predicting about an 80% chance</a> the Fed’s benchmark lending rate will top out around 5% this summer – which means they’re expecting rates to go just a little bit higher. </p>
<p>Rates on shorter-term borrowing are unlikely to come down, but if markets are right, they probably won’t increase much more.</p>
<p>However, for long-term borrowing costs, as on a 30-year mortgage, rates <a href="https://fred.stlouisfed.org/series/MORTGAGE30US">are already coming down</a> and are likely to fall some more – good news for homebuyers.</p>
<h2>How about inflation – can consumers expect prices to start falling?</h2>
<p>Overall, yes, inflation is already starting to come down – and <a href="https://theconversation.com/inflation-report-is-a-mixed-bag-an-economist-explains-why-some-items-are-rising-faster-than-others-197770">prices on some items are even falling</a>. </p>
<p>For example, used-car prices, which soared earlier in the COVID-19 pandemic, <a href="https://fred.stlouisfed.org/series/CUUR0000SETA02#0">have dropped</a> in recent months, while <a href="https://www.bls.gov/news.release/cpi.t02.htm">prices of dozens of other items</a>, such as flour, clothes and gasoline, have eased. </p>
<p>However, some costs continue to increase. <a href="https://fred.stlouisfed.org/series/APU0000708111">Egg prices soared</a> after the supply was disrupted because of avian flu, which <a href="https://www.npr.org/2022/12/02/1140076426/what-we-know-about-the-deadliest-u-s-bird-flu-outbreak-in-history">killed off nearly 53 million egg-laying hens</a>. Unfortunately, increasing interest rates will not bring back those birds or help decrease the cost of eggs. </p>
<p>In addition, nothing the Fed does will affect the war in Ukraine, which has led to <a href="https://www.nytimes.com/2022/08/01/business/wheat-ukraine-war-market.html#:%7E:text=The%20price%20of%20a%20widely,global%20hub%20for%20the%20commodity.">higher world wheat and energy prices</a>. </p>
<p>The point being, the Fed can’t really address certain types of inflation.</p>
<h2>Does all this mean the U.S. will avoid recession?</h2>
<p>That’s the trillion-dollar question. </p>
<p><a href="https://www.bloomberg.com/news/articles/2023-02-01/fed-slows-rate-hikes-signals-further-increases-are-coming?srnd=premium&sref=Hjm5biAW">Fed officials have at times sounded hopeful</a> that they can bring down inflation without crashing the economy – a so-called soft landing. During his press conference after the latest announcement Feb. 1, 2023, Fed Chair Jerome Powell <a href="https://finance.yahoo.com/news/federal-reserve-interest-rates-decision-february-1-174421486.html">was more cautious</a>, saying it’s too soon to declare victory. But he noted: “<a href="https://finance.yahoo.com/news/federal-reserve-interest-rates-decision-february-1-174421486.html">We can now say for the first time that the disinflationary process has started</a>.”</p>
<p>Economic forecasters have been less confident that the U.S. will avoid a recession. On average, economists surveyed this past month by The Wall Street Journal <a href="https://www.wsj.com/articles/despite-easing-price-pressures-economists-in-wsj-survey-still-see-recession-this-year-11673723571">forecast a 61% probability</a> of a recession in 2023. In addition, <a href="https://www.conference-board.org/topics/us-leading-indicators">key economic indicators point</a> to a recession, while the yield curve – a bond market metric that has been successful at predicting recessions – <a href="https://www.newyorkfed.org/research/capital_markets/ycfaq#/interactive">currently puts the odds</a> at about 47%.</p>
<p>In my view, this all adds up to: Nobody really knows. My best advice to consumers out there is to prepare financially for a recession, but let’s not give up hope that the Fed can slow the economy without crashing it.</p><img src="https://counter.theconversation.com/content/199057/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>William Chittenden does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>The Fed lifted its benchmark interest rate just 0.25 percentage point following a series of much more aggressive rate hikes in 2022.William Chittenden, Associate Professor of Finance, Texas State UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1850082022-06-14T20:40:58Z2022-06-14T20:40:58Z5 things to know about the Fed’s biggest interest rate increase since 1994 and how it will affect you<figure><img src="https://images.theconversation.com/files/469079/original/file-20220615-11-63gzwy.jpg?ixlib=rb-1.1.0&rect=152%2C38%2C4933%2C3347&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Wall Street is following Fed rate hike news with rapt attention.</span> <span class="attribution"><a class="source" href="https://newsroom.ap.org/detail/FinancialMarketsWallStreet/d2818af5986b470aaf03d5dba065759d/photo?Query=federal%20reserve&mediaType=photo&sortBy=arrivaldatetime:desc&dateRange=Anytime&totalCount=9007&currentItemNo=10">AP Photo/Seth Wenig</a></span></figcaption></figure><p><em>The <a href="https://www.federalreserve.gov/newsevents/pressreleases/monetary20220615a.htm">Federal Reserve on June 15, 2022</a>, <a href="https://www.bloomberg.com/news/articles/2022-06-15/fed-hikes-rates-75-basis-points-intensifying-inflation-fight?sref=Hjm5biAW">lifted interest rates</a> by 0.75 percentage point, the third hike this year and the <a href="https://www.federalreserve.gov/monetarypolicy/openmarket_archive.htm">largest since 1994</a>. The move is aimed at countering the <a href="https://theconversation.com/inflation-hits-fresh-40-year-high-pushing-fed-to-get-more-aggressive-with-interest-rates-and-the-beveridge-curve-should-give-it-courage-to-do-so-184896">fastest pace of inflation in over 40 years</a>.</em></p>
<p><em>Wall Street had been expecting a half-point increase, but the <a href="https://www.bls.gov/news.release/cpi.nr0.htm">latest consumer prices report</a> released on June 10 prompted the Fed to take a more drastic measure. The big risk, however, is that higher rates will push the economy into a recession, a fear aptly expressed by the recent <a href="https://finance.yahoo.com/news/bo-fa-survey-investor-misery-stock-market-enters-bear-market-105822248.html">plunge in the S&P 500 stock index</a>, which is down over 20% from its peak in January, making it a “bear market.”</em></p>
<p><em>What does this all mean? We asked Brian Blank, a <a href="https://scholar.google.com/citations?user=VxWst50AAAAJ&hl=en&oi=ao">finance scholar</a> who <a href="https://www.sciencedirect.com/science/article/abs/pii/S0929119921002406">studies how businesses adapt and handle economic downturns</a>, to explain what the Fed is trying to do, whether it can succeed and what it means for you.</em></p>
<h2>1. What is the Fed doing and why?</h2>
<p>The Federal Open Market Committee, the Fed’s policymaking arm, had been pondering how much and how quickly to raise its benchmark interest rate over the coming months to fight inflation. The stakes for the U.S. economy, consumers and businesses are very high.</p>
<p>Only a week ago, the <a href="https://www.bloomberg.com/news/articles/2022-05-12/powell-reiterates-half-point-hikes-are-likely-in-june-and-july">Fed had been expected</a> to raise rates by 0.5 percentage point at the latest meeting. But <a href="https://www.wsj.com/articles/bad-inflation-reports-raise-odds-of-surprise-0-75-percentage-point-rate-rise-this-week-11655147927">markets and Wall Street economists began to expect</a> the larger 0.75-point hike after the May consumer price data suggested inflation has been unexpectedly stubborn. Some Wall Street analysts <a href="https://www.bloomberg.com/news/articles/2022-06-13/wall-street-floats-100-basis-point-fed-hike-as-inflation-stings">even argued</a> a <a href="https://www.bloomberg.com/news/articles/2022-06-13/wall-street-floats-100-basis-point-fed-hike-as-inflation-stings">1-percentage-point hike was possible</a>.</p>
<p>The prospect of a faster pace of rate hikes due to inflation has prompted <a href="https://www.bloomberg.com/quote/SPX:IND?sref=Hjm5biAW">financial markets to plunge by over 6%</a> since the June 10 report. Investors worry the Fed may slow the economy too much in <a href="https://theconversation.com/how-raising-interest-rates-curbs-inflation-and-what-could-possibly-go-wrong-176426">its fight to reduce inflation</a>, which if left unchecked also <a href="https://www.thebalance.com/inflation-impact-on-economy-3306102">poses serious problems</a> for consumers and companies. A recent poll found that inflation <a href="https://www.pewresearch.org/fact-tank/2022/05/12/by-a-wide-margin-americans-view-inflation-as-the-top-problem-facing-the-country-today/">is the biggest problem</a> Americans believe the U.S. is facing right now.</p>
<h2>2. What is the Fed trying to achieve?</h2>
<p>The <a href="https://www.federalreserveeducation.org/about-the-fed/structure-and-functions/monetary-policy">Federal Reserve has a dual mandate to maximize employment while keeping prices stable</a>.</p>
<p>Often policymakers must prioritize one or the other. When the economy is weak, inflation is usually subdued and the Fed can focus on keeping rates down to stimulate investment and boost employment. When the economy is strong, unemployment is typically quite low, and that allows the Fed to focus on controlling inflation. </p>
<p>To do this, the Fed sets short-term interest rates, which in turn help it influence long-term rates. For example, when the Fed lifts its target short-term rate, that increases borrowing costs for banks, which in turn pass those higher costs on to consumers and businesses in the form of higher rates on <a href="https://www.stlouisfed.org/on-the-economy/2017/october/increases-fed-funds-rate-impact-other-interest-rates">long-term loans for houses and cars</a>. </p>
<p>At the moment, the <a href="https://fred.stlouisfed.org/series/RECPROUSM156N">economy is quite strong</a>, <a href="https://www.bls.gov/news.release/pdf/empsit.pdf">unemployment is
low</a>, and the Fed is able to focus primarily on reducing inflation. The problem is, inflation is so high, at <a href="https://www.bls.gov/news.release/cpi.nr0.htm">an annualized rate of 8.6%</a>, that bringing it down may require the highest interest rates in decades, which could weaken the economy substantially. </p>
<p>And so the Fed is trying to execute a so-called soft landing. </p>
<figure class="align-center ">
<img alt="A white guy with graying hair speaks standing in front of US flag" src="https://images.theconversation.com/files/469078/original/file-20220615-21-jl2hwl.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/469078/original/file-20220615-21-jl2hwl.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=400&fit=crop&dpr=1 600w, https://images.theconversation.com/files/469078/original/file-20220615-21-jl2hwl.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=400&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/469078/original/file-20220615-21-jl2hwl.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=400&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/469078/original/file-20220615-21-jl2hwl.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=503&fit=crop&dpr=1 754w, https://images.theconversation.com/files/469078/original/file-20220615-21-jl2hwl.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=503&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/469078/original/file-20220615-21-jl2hwl.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=503&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
<figcaption>
<span class="caption">Federal Reserve Chairman Jerome Powell announced a rate hike of 0.75 percentage point on June 15, 2022.</span>
<span class="attribution"><a class="source" href="https://newsroom.ap.org/detail/FederalReservePowell/7c915f351dac459499bfae4709930cf7/photo?Query=federal%20reserve&mediaType=photo&sortBy=arrivaldatetime:desc&dateRange=Anytime&totalCount=9007&currentItemNo=18">AP Photo/Jacquelyn Martin</a></span>
</figcaption>
</figure>
<h2>3. What’s a ‘soft landing’ and is it likely?</h2>
<p>A soft landing refers to the way that the Fed is attempting to slow inflation – and therefore economic growth – without causing a <a href="https://www.nber.org/research/business-cycle-dating">recession</a>.</p>
<p>In order to stabilize prices while not hurting employment, the <a href="https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20220615.pdf">Fed expects</a> to increase interest rates very rapidly in the coming months. Including the latest rate hike, the Fed has already lifted rates by 1.5 percentage points this year, putting its benchmark interest rate at a range of 1.5% to 1.75%.</p>
<p>Historically, when the Fed <a href="https://fred.stlouisfed.org/series/FEDFUNDS">has had to raise rates quickly</a>, economic downturns have been difficult to avoid. Can it manage a soft landing this time? <a href="https://www.marketplace.org/2022/05/12/fed-chair-jerome-powell-controlling-inflation-will-include-some-pain/">Fed Chair Jerome Powell has insisted</a> that the central bank’s policy tools have become more effective since its last inflation fight in the 1980s, making it possible this time to stick the landing. <a href="https://theconversation.com/fed-hopes-for-soft-landing-for-the-us-economy-but-history-suggests-it-wont-be-able-to-prevent-a-recession-182270">Many economists</a> and other observers remain uncertain. And a <a href="https://fortune.com/2022/06/13/recession-economists-survey-2023-inflation-interest-rates/">recent survey of economists</a> notes that many anticipate a recession beginning next year.</p>
<p>That said, the economy <a href="https://www.nytimes.com/2022/06/03/business/economy/forecasters-expect-job-gains-to-slow-yet-remain-solid.html">is still relatively strong</a>, and I’d say the the odds of a recession beginning next year are still <a href="https://www.schwab.com/learn/story/recession-blues-unfounded-fear">probably close to a coin flip</a>. </p>
<h2>4. Is there any way to tell what the Fed might do next?</h2>
<p>Each time the Federal Open Market Committee meets, it seeks to communicate what it plans to do in the future to help financial markets know what to expect so they aren’t taken by surprise.</p>
<p>One piece of guidance about the future that the committee provides is a series of dots, with each point representing a particular member’s expectation for interest rates at different points in time. <a href="https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20220316.pdf">This “dot plot</a>” previously indicated that the Fed will raise interest rates to 2% by the end of the year and close to 3% by the end of 2023.</p>
<p>The latest inflation news is forcing it to change its tune. The <a href="https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20220615.pdf">dot plot now suggests the Fed expects rates</a> to near 3.5% by December – implying several large rate hikes are still in store this year – and almost 4% in 2023 before falling again in 2024.</p>
<p>Long-term interest rates, such as <a href="https://home.treasury.gov/resource-center/data-chart-center/interest-rates/TextView?type=daily_treasury_yield_curve&field_tdr_date_value_month=202206">U.S. Treasury yields</a> and <a href="https://www.mortgagenewsdaily.com/markets/mortgage-rates-06112022">mortgage rates</a>, already reflect these rapid changes. Some investors, however, think the Fed may have to move even faster and are forecasting rates approaching <a href="https://www.atlantafed.org/cenfis/market-probability-tracker">4% by the end of 2022</a>. </p>
<h2>5. What does this mean for consumers and the economy?</h2>
<p>Interest rates represent the cost of borrowing, so when the Fed raises the target rate, money becomes more expensive to borrow. </p>
<p>First, banks pay more to borrow money, but then they charge individuals and businesses more interest as well, which is why mortgage rates rise accordingly. This is one reason <a href="https://www.bloomberg.com/news/articles/2022-03-04/what-s-the-average-mortgage-payment-monthly-cost-hits-record-for-30-year-loan">mortgage payments</a> have been rising so rapidly in 2022, even as housing markets and prices start to slow down. </p>
<p>When interest rates are higher, fewer people can afford homes and fewer businesses can afford to invest in a new factory and hire more workers. As a result, higher interest rates can slow down the growth rate of the economy overall, while also curbing inflation.</p>
<p>And this isn’t an issue affecting just Americans. Higher interest rates in the U.S. <a href="https://www.federalreserve.gov/econres/ifdp/files/ifdp1227.pdf">can have similar impacts on the global economy</a>, whether by driving up their borrowing costs or increasing the value of the dollar, which makes it more expensive to purchase U.S. goods.</p>
<p>But what it ultimately means for consumers and everyone else will depend on whether the pace of inflation slows as much and as quickly as the Fed has been forecasting. </p>
<p><em>This article was updated to include results of FOMC interest rates announcement.</em></p><img src="https://counter.theconversation.com/content/185008/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>D. Brian Blank does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>The Fed raised interest rates the most in nearly three decades to fight stubborn inflation. A finance expert explains what’s happening, the risks and what it means for consumers.D. Brian Blank, Assistant Professor of Finance, Mississippi State UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1836602022-05-30T14:11:31Z2022-05-30T14:11:31ZGhana’s debt: the pros and cons of borrowing abroad versus at home<figure><img src="https://images.theconversation.com/files/466001/original/file-20220530-12-50lufn.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Ghana's borrowing has it on the verge of debt distress</span> <span class="attribution"><span class="source">Shutterstock</span></span></figcaption></figure><p>A government which decides to borrow – either because it has programmed a budget deficit or needs to refinance maturing debts – faces two, non-mutually exclusive possibilities: borrow domestically in the local currency or borrow externally in a foreign currency.</p>
<p>Developed countries borrow predominantly at home and in their currencies. This is because they have deep domestic financial markets. Developing countries are different. Their governments are more likely to supplement domestic borrowing with debt from abroad in foreign currencies. </p>
<p>There are a few options when borrowing from abroad: from other countries (bilateral), from multilateral institutions like the International Monetary Fund, World Bank and the African Development Bank, or from the international capital markets. </p>
<p>Ghana taps both domestic and overseas financial markets. It issued its first Eurobond in 2007, and since then has <a href="https://www.bloomberg.com/news/articles/2020-02-04/ghana-markets-sub-saharan-africa-s-longest-eurobond-to-date">borrowed</a> over US$15 billion. Since 2013 its external debt has been greater than its domestic debt. As of March 2022, the <a href="https://www.ghanaweb.com/GhanaHomePage/business/What-Akufo-Addo-said-about-Ghana-s-increasing-debt-in-2012-1545188">total debt stock</a> was US$ 55 billion (78% of GDP) . The <a href="https://allafrica.com/stories/202204260604.html#:%7E:text=Also%2C%20the%20external%20component%20of,38.7%20per%20cent%20of%20GDP.">external component</a> was estimated at US$ 28.4 billion representing 51.6% share of the total. </p>
<p>Domestic debt has been more expensive than external debt for a long time. The cost of borrowing from international capital markets ranges between 7% and 11% compared to <a href="https://www.bog.gov.gh/treasury-and-the-markets/interbank-interest-rates/">domestic market’s</a> 18%-22% . </p>
<h2>Borrowing local is expensive for Ghana</h2>
<p>A number of factors drive higher local borrowing costs. Here are some, though the list isn’t exhaustive.</p>
<p>First, local borrowing isn’t concessional. Concessional loans come with low interest and normally a grace period before principal repayments begin. But these loans are available only to poor countries that meet the criteria. Ghana doesn’t meet the criteria.</p>
<p>The second reason is related to high inflation and low domestic savings. Ghana’s <a href="https://www.ghanabusinessnews.com/2022/05/11/ghana-inflation-rate-for-april-2022-accelerates-to-23-6-from-19-4/">inflation rate </a>for April 2022 was 23.6%. No investor will invest at a rate lower than inflation because they will be making losses (negative real interest rate). Therefore, for the government to be able to attract investors, it will have to charge higher interest (usually above inflation rate).</p>
<p>A third reason that local debt is expensive is that Ghana’s domestic debt market is not yet deep and liquid. The small domestic debt market and a limited pool of funds means that restricts government to borrowing short-term and at higher interest rates.</p>
<p>The other reason foreign investors expect higher interest rates is because developing countries have a history of mismanaging their economies. Ghana has had its <a href="https://www.theafricareport.com/142654/ghanas-worsening-debt-market-access-means-imf-relief-needed-economists/">challenges</a> of economic management . This is evident in the <a href="https://www.theafricareport.com/174809/ghana-policy-credibility-depends-on-imf-package-after-moodys-downgrade/">number of times </a>the country had resorted to the IMF for a bailout. For the risk that foreign investors take, they expect a higher interest rates to compensate for the perceived risk.</p>
<h2>Borrowing abroad</h2>
<p>Commercial foreign loans come with lower interest rates than domestic loans debt.</p>
<p>This is partly because external borrowing provides access to a vast pool of long-term funds held by international development banks or investors in international capital markets. This is true of loans with concessional or nonconcessional terms.</p>
<p>Longer maturities – which means longer periods of time over which debt can be settled – are also obtainable in foreign capital markets. This is because they are deeper and more sophisticated than domestic markets. </p>
<p>Long-term borrowing reduces public debt roll-over risks. For its part short-term borrowing worsens roll-over risks.</p>
<p>Foreign borrowing is routinely defended on the grounds that it avoids crowding out private borrowing and investment, which is what happens when domestic borrowing drives up interest rates. This argument is given force especially when domestic savings are very low or the outstanding domestic debt stock is already huge, and it is feared that the marginal cost of additional debt would have to keep rising to persuade local bondholders to lend more money to the government.</p>
<h2>Grounds for coming home</h2>
<p>There is a case to be made against foreign-currency loans. The factors include:</p>
<p><strong>Foreign exchange risk</strong>: Even if the interest rate and other terms of a foreign loan are more favourable than domestic debt, the foreign loan might still be more expensive in the end. This is due to the inherent foreign exchange risk, whereby the cost of servicing the debt in local currency terms increases whenever the exchange rate depreciates (in a flexible or managed exchange rate regime) or is devalued (in a currency peg regime).</p>
<p>This worsens the burden of the debt on government revenue which is in local currency and raises debt service costs. At the same time, depreciation (or devaluation) raises the home currency value of outstanding foreign debt and depresses the foreign currency value of domestic revenue. This can lead to a country’s debt profile looking more vulnerable.</p>
<p>Investors may also perceive this situation as a deterioration of the government’s credit or default risk and demand higher interest rates on foreign borrowing. </p>
<p>By comparison, domestic debt doesn’t expose the government to currency risk and is therefore safe.</p>
<p><strong>Crowding-out effects</strong>: When money raised abroad flows into the country it must be exchanged for the domestic currency which risks causing inflation as the inflows will result in an increase in money supply. </p>
<p>External borrowing can also trigger an appreciation of the domestic currency, thereby squeezing out exporters.</p>
<p><strong>Debt service outflows</strong>: Interest paid on external debt is an outflow of resources abroad to foreigners, whose income and consumption are taxed by their own governments. It is not a domestic transfer that could yield tax revenue to the government. Accordingly, the domestic economy is worse off when foreign debt is serviced than when domestic debt is serviced. That is why there is the need to limit foreigners holding of the domestic bond.</p>
<p><strong>Bigger debt crisis risk</strong>: When overdone, all forms of borrowing can plunge a country into a debt crisis or lead to a default. However, the risk of a crisis is bigger with foreign debt. First, what a government owes to foreign investors can balloon without government taking on a new debt. The cause would be a sharp weakening of the domestic currency against the currency in which the foreign debt is denominating.</p>
<p><strong>Sovereignty</strong>: Dependence on external funds gives foreign creditors influence over domestic policy choices. This is facilitated, for example, through conditions attached to concessional loans given by international agencies, especially the IMF and World Bank.</p>
<p>In addition, disputes over foreign debt are typically adjudicated abroad whereas domestic debt is governed by domestic law, which the government has influence over.</p>
<p>Besides, to the extent that it is true, the argument that external sovereign debt acts as a disciplinary device over domestic policy decisions has a flip side. This is the fear that it could make a government beholden to foreign bondholders, whose expectations and interests would influence national policies, perhaps disproportionately and to the detriment of citizens’ interests.</p><img src="https://counter.theconversation.com/content/183660/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Adu Owusu Sarkodie does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>There are a number of reasons why Ghana’s domestic borrowing is more expensive than foreign debt.Adu Owusu Sarkodie, Lecturer, Department of Economics, University of GhanaLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1824712022-05-04T18:49:18Z2022-05-04T18:49:18ZFed hopes biggest rate hike in 22 years tames inflation without recession or stagflation: 3 essential reads on what it all means<figure><img src="https://images.theconversation.com/files/461383/original/file-20220504-21-laommk.jpg?ixlib=rb-1.1.0&rect=149%2C132%2C5393%2C3556&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Fed Chair Jerome Powell has a tough job in bringing down inflation without killing the economy. </span> <span class="attribution"><a class="source" href="https://newsroom.ap.org/detail/FederalReserve/5ded2ff2b2374244b5d8672b607a3847/photo?Query=federal%20reserve&mediaType=photo&sortBy=arrivaldatetime:desc&dateRange=Anytime&totalCount=8769&currentItemNo=1">AP Photo/Alex Brandon</a></span></figcaption></figure><p><em>The Federal Reserve on May 4, 2022, <a href="https://www.federalreserve.gov/newsevents/pressreleases/monetary20220504a.htm">lifted its benchmark interest rate</a> by half a percentage point to a range of 0.75% to 1%, <a href="https://www.bloomberg.com/news/articles/2022-05-04/fed-hikes-rates-half-point-will-shrink-assets-to-curb-inflation?srnd=premium&sref=Hjm5biAW">its biggest increase in 22 years</a>. The aggressive move, which has been expected for many months, is part of the U.S. central bank’s effort to slow the <a href="https://www.bls.gov/news.release/cpi.nr0.htm">fastest inflation in 40 years</a>. More rate hikes <a href="https://www.cnbc.com/2022/03/16/new-federal-reserve-projections-show-six-more-rate-hikes-this-year.html">are forecast in the coming months</a>.</em></p>
<p><em>Economists, financial markets and others <a href="https://www.nytimes.com/2022/04/05/business/economy/recession-economy.html">are concerned</a> that rising rates could send the economy into recession. Even worse, some worry higher rates could lead to what’s known as stagflation.</em></p>
<p><em>But how does the Fed get rising consumer prices under control, can it avoid the dreaded R word – recession – and what the heck is stagflation? In recent weeks, we’ve asked several experts to explain these complex topics to help readers better understand what’s at stake as the Fed takes on its biggest inflation fight in two generations. Here are excerpts from three of those articles.</em></p>
<h2>Cooling the economy</h2>
<p>The Fed’s main monetary policy tool is the federal funds rate, which acts as a benchmark for every other interest rate in the U.S. economy – from borrowing rates for mortgages to business loans. It also helps determine many other rates around the world. </p>
<p>When it goes up – or is expected to – consumers and businesses end up paying more to borrow for a new home or build a factory. As a result, <a href="https://theconversation.com/how-raising-interest-rates-curbs-inflation-and-what-could-possibly-go-wrong-176426">they buy less stuff and make fewer investments</a>, slowing the economy, explains <a href="https://scholar.google.com/citations?user=RYY7tWEAAAAJ&hl=en&oi=ao">Rodney Ramcharan</a>, who has studied how monetary policy affects the economy for decades while working at the Federal Reserve, the International Monetary Fund and now the University of Southern California. </p>
<p>“This is the cost to the economy when the Fed raises interest rates,” he writes. By cooling the economy and reducing demand, lifting interest rates also has the effect of slowing inflation.</p>
<p>But with inflation running at 8.5% year over year, “no one really knows how high interest rates might need to climb in order to get inflation back down” to the level the Fed prefers, around 2%, he adds. </p>
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<strong>
Read more:
<a href="https://theconversation.com/how-raising-interest-rates-curbs-inflation-and-what-could-possibly-go-wrong-176426">How raising interest rates curbs inflation – and what could possibly go wrong</a>
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<img alt="a shopper is looking at a supermarket display of a variety of meats and fish" src="https://images.theconversation.com/files/461339/original/file-20220504-21-c76318.jpg?ixlib=rb-1.1.0&rect=235%2C136%2C4725%2C2434&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/461339/original/file-20220504-21-c76318.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=337&fit=crop&dpr=1 600w, https://images.theconversation.com/files/461339/original/file-20220504-21-c76318.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=337&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/461339/original/file-20220504-21-c76318.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=337&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/461339/original/file-20220504-21-c76318.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=424&fit=crop&dpr=1 754w, https://images.theconversation.com/files/461339/original/file-20220504-21-c76318.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=424&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/461339/original/file-20220504-21-c76318.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=424&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
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<span class="caption">The prices of most meat and other products have been soaring lately.</span>
<span class="attribution"><a class="source" href="https://newsroom.ap.org/detail/NerdWallet-Kimberly-Palmer-Audit-Food-Spending/d1bbf3e80a4844598f93a1fe304f261d/photo?Query=prices%20and%20u.s.&mediaType=photo&sortBy=arrivaldatetime:desc&dateRange=Anytime&totalCount=14301&currentItemNo=5">AP Photo/Charles Krupa</a></span>
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<h2>Is recession inevitable?</h2>
<p>And there’s the rub.</p>
<p>The Fed says it’s serious about taming consumer prices and believes it can execute what’s known as a “soft landing,” in which inflation slows down without seriously damaging the economy. </p>
<p>But the higher rates go, the more economic activity will slow. If you ask <a href="https://www.hks.harvard.edu/about/alex-domash">Alex Domash</a> and <a href="https://www.hks.harvard.edu/faculty/lawrence-h-summers">Lawrence Summers</a> of the Harvard Kennedy School, they’ll tell you <a href="https://theconversation.com/fed-hopes-for-soft-landing-for-the-us-economy-but-history-suggests-it-wont-be-able-to-prevent-a-recession-182270">it’s already too late</a>. Based on their analysis of 70 years of efforts to do so, the Fed probably can’t prevent a recession. </p>
<p>“The history of engineering soft landings is not encouraging,” Domash and Summers write. “We found that every time the Fed has hit the brakes hard enough to bring down inflation in a meaningful way, the economy has gone into recession.”</p>
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<p>
<em>
<strong>
Read more:
<a href="https://theconversation.com/fed-hopes-for-soft-landing-for-the-us-economy-but-history-suggests-it-wont-be-able-to-prevent-a-recession-182270">Fed hopes for ‘soft landing’ for the US economy, but history suggests it won’t be able to prevent a recession</a>
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<p>[<em>You’re smart and curious about the world. So are The Conversation’s authors and editors.</em> <a href="https://memberservices.theconversation.com/newsletters/?source=inline-youresmart">You can read us daily by subscribing to our newsletter</a>.]</p>
<h2>The nightmare scenario</h2>
<p>That brings us to the nightmare scenario. What if the Fed successfully slows the economy but fails to meaningfully reduce inflation? </p>
<p>That’s stagflation – and for policymakers <a href="https://theconversation.com/why-stagflation-is-an-economic-nightmare-and-could-become-a-real-headache-for-biden-and-the-fed-if-it-emerges-in-the-us-179036">there’s almost nothing worse</a>, explains SUNY Old Westbury economist <a href="https://scholar.google.com/citations?user=GyTN5PYAAAAJ&hl=en&oi=ao">Veronika Dolar</a>. </p>
<p>“The problem is that the ways to fight either one of those two problems – high inflation, low growth – usually end up making the other one even worse,” she writes. “And that means solving the problem may simply depend on circumstances out of U.S. policymakers’ control, such as an end to the crisis in Ukraine or finding ways to immediately increase oil supply – which is tricky.”</p>
<p>It’s too soon to say whether the U.S. economy will experience stagflation, but it’s certainly on the minds of Fed policymakers. </p>
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<p>
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<strong>
Read more:
<a href="https://theconversation.com/why-stagflation-is-an-economic-nightmare-and-may-already-be-here-179036">Why stagflation is an economic nightmare – and may already be here</a>
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<p><em>Editor’s note: This story is a roundup of articles from The Conversation’s archives.</em></p><img src="https://counter.theconversation.com/content/182471/count.gif" alt="The Conversation" width="1" height="1" />
The Fed lifted its benchmark interest rate by half a percentage point as it fights raging inflation.Bryan Keogh, Managing EditorLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1764262022-02-10T13:42:44Z2022-02-10T13:42:44ZHow raising interest rates curbs inflation – and what could possibly go wrong<figure><img src="https://images.theconversation.com/files/445528/original/file-20220209-18418-1x2hixg.jpg?ixlib=rb-1.1.0&rect=95%2C191%2C4805%2C3071&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">The price of used cars has soared during the pandemic. </span> <span class="attribution"><a class="source" href="https://newsroom.ap.org/detail/Inflation/45798f3a91634cf38876e1ceab0a87d4/photo?Query=used%20car%20lot&mediaType=photo&sortBy=arrivaldatetime:desc&dateRange=Anytime&totalCount=245&currentItemNo=1">AP Photo/Matt Rourke</a></span></figcaption></figure><p>After about <a href="https://www.minneapolisfed.org/about-us/monetary-policy/inflation-calculator/consumer-price-index-1913-">three decades of relatively low inflation</a>, consumer prices are skyrocketing again. </p>
<p>The price of gasoline, for example, <a href="https://www.bls.gov/news.release/cpi.t02.htm">was up 40% in January 2022</a> from a year earlier, while used cars and trucks jumped 41%, according to data released on Feb. 10, 2022. Other categories experiencing high inflation include hotels, eggs, and fats and oils, up 24%, 13% and 11%, respectively. On average, <a href="https://www.bls.gov/news.release/cpi.nr0.htm">prices climbed about 7.5%</a>, the fastest pace of inflation since 1982. </p>
<p>It’s <a href="https://www.chicagofed.org/research/dual-mandate/dual-mandate">part of the mandated job</a> of the U.S. Federal Reserve to prevent inflation from getting out of hand – and lowering it back to its preferred pace of about 2%. </p>
<p>To do that, the Fed has signaled it plans to raise interest rates several times this year – perhaps <a href="https://www.reuters.com/world/us/goldman-sachs-expecting-five-rate-hikes-this-year-2022-01-29/">as many as five</a> – beginning in March. And January’s <a href="https://www.bloomberg.com/news/articles/2022-02-10/u-s-inflation-charges-higher-with-larger-than-forecast-gain?srnd=premium">faster-than-expected inflation figures</a> suggest it may have to accelerate its overall timetable. </p>
<p>Will this work? If so, why? </p>
<p>I’m an <a href="https://scholar.google.com/citations?user=RYY7tWEAAAAJ&hl=en&oi=ao">economist who has been studying how monetary policy affects the economy</a> for decades while working at the Federal Reserve, the International Monetary Fund and now the University of Southern California. I believe the answer to the first question is most likely yes – but it will come at a cost. Let me explain why.</p>
<p><iframe id="6T5Sl" class="tc-infographic-datawrapper" src="https://datawrapper.dwcdn.net/6T5Sl/1/" height="400px" width="100%" style="border: none" frameborder="0"></iframe></p>
<h2>Higher rates reduce demand</h2>
<p>The Federal Reserve controls the <a href="https://www.newyorkfed.org/markets/reference-rates/effr">federal funds rate</a>, often referred to as its target rate.</p>
<p>This is the interest rate that banks use to make overnight loans to each other. Banks borrow money – sometimes from each other – to make loans to consumers and businesses. So when the Fed raises its target rate, it raises the cost of borrowing for banks that need funds to lend out or meet their regulatory requirements.</p>
<p>Banks naturally pass on these higher costs to consumers and businesses. This means that if the Fed raises its federal funds rate by 25 basis points, or 0.25 percentage point, consumers and businesses will also have to pay more to borrow money – just how much more depends on many factors, including the maturity of the loan and how much profit the bank wants to make.</p>
<p>This higher cost of borrowing in turn dampens demand and economic activity. For example, if a car loan becomes more expensive, maybe you’ll decide now is not the right time to buy that new convertible or pickup truck you had your eye on. Or perhaps a business will become less likely to invest in a new factory – and hire additional workers – if the interest it would pay on a loan to finance it goes up.</p>
<p>This is the cost to the economy when the Fed raises interest rates.</p>
<h2>And reduced demand lowers inflation</h2>
<p>At the same time, this is exactly what slows the pace of inflation. Prices for goods and services typically go up when demand for them rises. But when it becomes more expensive to borrow, there’s less demand for goods and services throughout the economy. Prices may not necessarily go down, but their rate of inflation will usually decline. </p>
<p>To see an example of how this works, consider a used car dealership, where the pace of inflation <a href="https://fred.stlouisfed.org/series/CUSR0000SETA02">has been exceptionally high</a> throughout the pandemic. Let’s assume for the moment that the dealer has a fixed inventory of 100 cars on its lot. If the overall cost of buying one of those cars goes up – because the interest rate on the loan needed to finance one rises – then demand will drop as fewer consumers show up on the lot. In order to sell more cars, the dealer will likely have to cut prices to entice buyers. </p>
<p>In addition, the dealer faces higher borrowing costs, not to mention tighter profit margins after reducing prices, which means perhaps it couldn’t afford to hire all the workers it had planned to, or even has to lay off some employees. As a result, fewer people may be able to even afford the down payment, further reducing demand for cars. </p>
<p>Now imagine it’s not just one dealer seeing a drop in demand but an <a href="https://fred.stlouisfed.org/series/GDP">entire US$24 trillion economy</a>. Even small increases in interest rates can have ripple effects that significantly slow down economic activity, limiting the ability of companies to raise prices. </p>
<h2>The risks of raising rates too quickly</h2>
<p>But our example assumes a fixed supply. As we’ve seen, the global economy has been dealing with <a href="https://theconversation.com/why-you-should-expect-more-suez-like-supply-chain-disruptions-and-shortages-at-your-local-grocery-store-158266">massive supply chain disruptions</a> and shortages. And these problems have driven up production costs in other parts of the world. </p>
<p>If high U.S. inflation stems mainly from these higher production costs and low inventories, then the Fed might have to raise interest rates by a great deal to contain inflation. And the higher and faster the Fed has to raise rates, the more harmful it will be to the economy. </p>
<p>In keeping with our car example, if the price of computer chips – a <a href="https://www.motorbiscuit.com/what-do-semiconductor-chips-do-in-cars/">critical input in cars these days</a> – is increasing sharply primarily because of <a href="https://www.nytimes.com/2022/01/16/business/economy/china-supply-chain-covid-lockdowns.html">new pandemic-related lockdowns in Asia</a>, then carmakers will have to pass on these higher prices to consumers in the form of higher car prices, regardless of interest rates. </p>
<p>In this case, the Fed might then have to dramatically raise interest rates and reduce demand substantially to slow the pace of inflation. At this point, no one really knows how high interest rates might need to climb in order to get inflation back down to around 2%. </p>
<p><em>Updated to note impact of January inflation figures on Fed.</em></p>
<p>[<em>You’re smart and curious about the world. So are The Conversation’s authors and editors.</em> <a href="https://memberservices.theconversation.com/newsletters/?source=inline-youresmart">You can read us daily by subscribing to our newsletter</a>.]</p><img src="https://counter.theconversation.com/content/176426/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Rodney Ramcharan does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Higher interest rates reduce demand for goods and services, which makes it harder for companies to raise prices. But there are risks as well.Rodney Ramcharan, Associate Professor of Finance and Business Economics, University of Southern CaliforniaLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1757912022-01-26T22:50:16Z2022-01-26T22:50:16ZFederal Reserve plans to raise interest rates ‘soon’ to fight inflation: What that means for consumers and the economy<figure><img src="https://images.theconversation.com/files/442823/original/file-20220126-17-12pu2mv.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">All eyes are on Fed Chair Jerome Powell as the central bank prepares to raise rates for the first time in three years. </span> <span class="attribution"><a class="source" href="https://newsroom.ap.org/detail/OffTheCharts-MoneyPrinter/a6f1d62158b34b549e3c907ed60bddeb/photo?Query=federal%20reserve&mediaType=photo&sortBy=arrivaldatetime:desc&dateRange=Anytime&totalCount=8573&currentItemNo=17">Brendan Smialowski/Pool via AP</a></span></figcaption></figure><p><em>The Federal Reserve on Jan. 26, 2022, <a href="https://www.federalreserve.gov/newsevents/pressreleases/monetary20220126a.htm">signaled plans to begin raising interest rates “soon”</a> – possibly in March – in a bid to tamp down inflation before it poses a serious risk to the U.S. economy. A separate report released the next day <a href="https://www.bloomberg.com/news/articles/2022-01-27/u-s-economic-growth-quickened-last-quarter-with-inventory-boost?srnd=premium&sref=Hjm5biAW">showed the economy grew 6.9% in the fourth quarter of 2021</a>. An interest rate hike would be the first time the central bank has increased its benchmark lending rate in over three years.</em></p>
<p><em>Lifting the borrowing costs consumers and businesses pay for loans has the effect of slowing economic activity, which in turn could curb inflation. But there are also concerns that it could put on the brakes too quickly. We asked <a href="https://scholar.google.com/citations?user=JfUEmSUAAAAJ&hl=en&oi=ao">Alexander Kurov</a>, a finance professor at West Virginia University, and <a href="https://scholar.google.com/citations?user=dnCoKIUAAAAJ&hl=en&oi=ao">Marketa Wolfe</a>, an economist at Skidmore College, to explain what the Fed is doing and what it means for you.</em> </p>
<h2>1. Why is the Fed raising interest rates?</h2>
<p>Short-term interest rates in the U.S. <a href="https://fred.stlouisfed.org/series/FEDFUNDS">are now essentially zero</a>.</p>
<p>The Fed quickly cut rates to zero at the beginning of the COVID-19 crisis in March 2020 in an attempt to soften the blow of the <a href="https://www.nber.org/research/data/us-business-cycle-expansions-and-contractions">sharp recession that began that month</a> as the U.S. went into lockdown. As a reminder of how bad things were back then, <a href="https://fred.stlouisfed.org/series/ICSA">over 40 million workers</a> – a quarter of the American workforce – filed for unemployment in the first few months of the pandemic, a staggering number with no precedent in the job market.</p>
<p>Although the recession was short-lived – lasting only two months – and the <a href="https://www.cnn.com/business/us-economic-recovery-coronavirus">economy has mostly recovered</a>, the Fed has kept rates at rock bottom because <a href="https://www.vox.com/the-highlight/22665191/covid-economy-poverty-unemployment">many workers and businesses still need support</a> as the pandemic continues to rage. </p>
<p>The big problem for the Fed now is that U.S. consumer prices have surged. For 10 months in a row, inflation has been above the <a href="https://www.federalreserve.gov/faqs/economy_14400.htm">Fed’s 2% target</a> and <a href="https://www.bls.gov/news.release/cpi.nr0.htm">reached an annual pace of about 7% in December</a>. This is the <a href="https://fred.stlouisfed.org/graph/?g=8dGq">highest rate of inflation recorded in the U.S. in the last 40 years</a>. High inflation means the prices people pay for goods and services are continually going up – <a href="https://www.bls.gov/news.release/cpi.nr0.htm">especially for basic items</a> like meat and gasoline, as well as for manufactured goods like cars. </p>
<p>The Fed can ill afford to allow this to continue because if higher inflation becomes entrenched, it <a href="https://www.ft.com/content/ddd02d7a-1557-4357-af6f-7c433da1b406">would damage the economy</a>. And the longer it lasts, the harder – and more painful for consumers and businesses – it is going to be to bring it back to a more sustainable 2%. </p>
<p>So the Fed has to act quickly before it’s too late. </p>
<h2>2. How does the Fed raise rates?</h2>
<p>The Fed sets a target range for what is called the “<a href="https://www.chicagofed.org/research/dual-mandate/the-federal-funds-rate">federal funds rate</a>.” This rate acts like a benchmark for all interest rates in the economy. </p>
<p>While the Fed’s statement didn’t specify a time when it plans to raise rates, <a href="https://www.nytimes.com/2022/01/26/business/economy/fed-interest-rates-inflation.html">Chair Jerome Powell said</a> “the committee is of a mind to raise the federal funds rate at the March meeting, assuming that the conditions are appropriate for doing so. <a href="https://www.bloomberg.com/news/articles/2022-01-26/fed-signals-liftoff-soon-sees-asset-reduction-start-afterward?srnd=premium&sref=Hjm5biAW">Analysts expect it to be a 0.25 percentage point increase</a>. This would affect banks’ cost of borrowing, which in turn slowly filters throughout the economy as lenders charge more for loans on homes, cars, businesses, college tuition and anything else you might want to buy with debt. Banks would also gradually increase the interest they offer on deposits and savings accounts. </p>
<p>The Fed does not directly control all these other rates, and the exact path they will take is not completely predictable, but the overall trend will be up if the Fed keeps raising its target rate. </p>
<p>Markets expect the Fed to raise interest rates <a href="https://www.reuters.com/business/fed-raise-rates-three-times-this-year-tame-unruly-inflation-2022-01-20/">at least two more times in 2022</a>. </p>
<h2>3. What does that mean for consumers and businesses?</h2>
<p>Put simply, higher interest rates mean borrowers would need to pay more for the loans they get. </p>
<p>If the Fed lifts interest rates this year by 0.75 percentage point, as expected, this would translate into about US$45,000 in additional interest payments on a 30-year, $300,000 mortgage.</p>
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<p>So if you want to borrow to start a business, pay for college, buy a car or do anything else, you should expect your borrowing costs to be higher later this year. </p>
<p>On the other hand, higher rates is good news for savers and investors, as their returns from activities like making deposits and buying bonds will go up. </p>
<h2>4. And how will it affect the broader economy?</h2>
<p>Higher interest rates would likely slow down business activity. While this can help reduce inflation, it also means lower economic growth. </p>
<p>The Fed always makes decisions based on what is happening in the economy and on how economic conditions are expected to change. And changes in the economy are often hard to predict.</p>
<p>The biggest unknown at this point is what will happen to inflation later this year. This is uncertain because inflation is <a href="https://www.cwmnw.com/blog/all-you-need-to-know-about-inflation-the-reality-of-supply-chain-shortages-and-money-supply">driven by multiple factors</a>, such as supply chain shortages and strong demand. </p>
<p>In addition, the <a href="https://fred.stlouisfed.org/series/CIVPART">labor force participation rate</a> has still not recovered to pre-pandemic levels, and the economy <a href="https://www.cbsnews.com/news/covid-small-businesses-inflation-supply-chain-recruiting-federal-aid/">is experiencing labor shortages</a>, which could push wages and prices higher. If these COVID-19-related pressures don’t ease up soon, inflation could continue to stay high or continue to accelerate, which may force the Fed to increase interest rates faster than currently expected. </p>
<p>On the other hand, if economic or employment growth stalls, this will make it much harder for the Fed to raise rates without making things worse. The Fed will need to find the right balance between taming inflation and avoiding slowing down the economy too much. </p>
<p><em>Article updated to add GDP report and Powell comment.</em></p><img src="https://counter.theconversation.com/content/175791/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>The authors do not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and have disclosed no relevant affiliations beyond their academic appointment.</span></em></p>The US central bank said surging inflation is guiding its decision about when to lift interest rates. Two experts on financial markets explain what might happen next.Alexander Kurov, Professor of Finance and Fred T. Tattersall Research Chair in Finance, West Virginia UniversityMarketa Wolfe, Associate Professor of Economics, Skidmore CollegeLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1337392020-03-16T16:33:35Z2020-03-16T16:33:35ZThe Fed will have to do a lot more than cut rates to zero to stop Wall Street’s coronavirus panic<figure><img src="https://images.theconversation.com/files/320820/original/file-20200316-27648-rq75cq.jpg?ixlib=rb-1.1.0&rect=80%2C59%2C3513%2C2274&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">A sea of red.</span> <span class="attribution"><span class="source">AP Photo/Craig Ruttle</span></span></figcaption></figure><p>The Federal Reserve is 0 for 2 in its fight against Wall Street’s coronavirus panic, seeming to confirm perceptions of the <a href="https://www.wsj.com/articles/the-fed-put-has-no-clothes-11584123743">central bank’s impotence</a>. </p>
<p>The Fed’s first attempt to calm thing down – a <a href="https://theconversation.com/the-feds-surprise-interest-rate-cut-5-questions-answered-132957">half-point surprise rate cut</a> on March 3 – failed because markets knew the Fed was almost out of ammunition on rate cuts. Its second effort on March 15 – a full percentage point cut in a very rare weekend action – <a href="https://www.nytimes.com/2020/03/15/business/stock-market-today-coronavirus.html">failed</a> because, well, the Fed actually is out of ammunition. </p>
<p>As a finance professor who does <a href="https://scholar.google.com/citations?user=JfUEmSUAAAAJ&hl=en">research on how Fed policy affects financial markets</a>, I believe that to make a real difference in what’s happening in the markets, the U.S. central bank will need to do what it did a decade ago to calm markets: whatever it takes. </p>
<p>And that means once again reaching into the unknown. </p>
<h2>Go big or go home</h2>
<p>During the 2008-2009 financial crisis, markets <a href="https://www.thebalance.com/stock-market-crash-of-2008-3305535">were in free fall for months</a> before calm was restored and assets like stocks started climbing again. </p>
<p>One of the main things that changed was that policymakers finally demonstrated they were ready to do whatever it took to return things to normal. The federal government committed about <a href="https://en.wikipedia.org/wiki/Emergency_Economic_Stabilization_Act_of_2008">US$1 trillion</a> to support the banks, bail out automakers and shore up mortgage lenders. </p>
<p>At the same time, the Fed not only cut interest rates from <a href="https://fred.stlouisfed.org/series/DFEDTAR">5.25%</a> to <a href="https://fred.stlouisfed.org/graph/?g=qo7y">zero</a> but unleashed an unprecedented set of measures in an effort to keep credit markets from seizing up, shore up liquidity and become the lender of last resort for a variety of financial institutions. For example, the Fed’s large program of bond buying, known as <a href="https://www.thebalance.com/what-is-quantitative-easing-definition-and-explanation-3305881">quantitative easing</a>, helped stimulate the economy by lowering interest rates for a variety of bonds and loans. The Fed <a href="https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm">held over $4 trillion</a> in securities at the program’s peak in 2015. </p>
<figure class="align-center ">
<img alt="" src="https://images.theconversation.com/files/320809/original/file-20200316-27692-1wqc7v7.jpg?ixlib=rb-1.1.0&rect=88%2C97%2C5302%2C3492&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/320809/original/file-20200316-27692-1wqc7v7.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=400&fit=crop&dpr=1 600w, https://images.theconversation.com/files/320809/original/file-20200316-27692-1wqc7v7.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=400&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/320809/original/file-20200316-27692-1wqc7v7.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=400&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/320809/original/file-20200316-27692-1wqc7v7.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=503&fit=crop&dpr=1 754w, https://images.theconversation.com/files/320809/original/file-20200316-27692-1wqc7v7.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=503&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/320809/original/file-20200316-27692-1wqc7v7.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=503&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
<figcaption>
<span class="caption">It’s been a tough few weeks on Wall Street.</span>
<span class="attribution"><span class="source">AP Photo/Mark Lennihan</span></span>
</figcaption>
</figure>
<h2>Warning signs</h2>
<p>Today, markets across the globe are making it clear that things are getting worse and policymakers need to do a lot more to ease the frayed nerves of investors. </p>
<p>It’s not just stocks tanking. A broad range of credit markets are also <a href="https://www.nytimes.com/2020/03/12/business/economy/wall-street-funding-troubles-fed.html">beginning to seize up</a>, just as <a href="https://www.cnbc.com/id/26762806">they did</a> in 2008. Two of the markets in particular reveal how bad things have gotten.</p>
<p>Normally, when stocks tumble, bonds issued by very strong companies like Microsoft and Johnson & Johnson go up because they’re seen as a haven, just like U.S. Treasuries. But <a href="https://fred.stlouisfed.org/series/DAAA">their prices are going down</a>, which means their yields – which in effect is what companies will have to pay to borrow money – <a href="https://fred.stlouisfed.org/series/AAA10Y">are going up</a> quickly.</p>
<p>Similarly, the market for commercial paper – basically, very short-term corporate IOUs – <a href="https://www.bloomberg.com/news/articles/2020-03-15/key-source-of-corporate-cash-seizing-up-amid-credit-market-rout?srnd=premium&sref=Hjm5biAW">is beginning to seize up</a>. This is some of the safest debt around, primarily issued by top-grade companies – and usually paid back within days – to buy inventory or make payrolls. Back in 2008, stress in this market <a href="http://pages.stern.nyu.edu/%7Esternfin/mkacperc/public_html/commercial.pdf">caused a run on money market funds</a> and only calmed when the Fed began buying commercial paper directly for the first time in its history.</p>
<p>If problems like these continue, it will <a href="https://www.economist.com/finance-and-economics/2020/03/12/corporate-bonds-and-loans-are-at-the-centre-of-a-new-financial-scare">put serious strain on corporate borrowers</a>. Coupled with the direct economic shock of what is happening, this may lead to bankruptcies and mass layoffs, making the downturn even worse. It will also send the message that the only safe haven for investors is in Treasury bills.</p>
<h2>Getting ahead of the curve</h2>
<p>So far, the Fed’s actions have helped to keep markets from seizing up. But in a fast-moving crisis, the Fed seems to be reacting to events instead of trying to anticipate them.</p>
<p>The latest cut, coming a few days ahead of a regularly scheduled meeting, was coupled with a plan to buy $700 billion in Treasury bonds and mortgage-backed securities, effectively restarting its quantitative easing program. </p>
<p>This is a good start. But, just as in 2008, the Fed will likely have to do things <a href="https://www.reuters.com/article/us-usa-fed-yellen-purchases/yellen-says-fed-purchases-of-stocks-corporate-bonds-could-help-in-a-downturn-idUSKCN11Z2WI">it’s never done before</a> to solve the problem. That may involve finding new ways to keep overall credit conditions from getting worse. Otherwise, the economic shock of the coronavirus pandemic may inflict lasting damage on businesses and households.</p>
<p>The crisis could be tackled in a variety of ways. I’m not advocating a specific approach. The point is that the Fed needs to show markets it understands the seriousness of this crisis and, just as in 2008, will be the lender of last resort and will do whatever is necessary to ease financial stress.</p>
<p>Fed Chairman Jerome Powell <a href="https://www.forexfactory.com/news/986491-transcript-of-chair-powells-press-conference-opening-remarks">helpfully noted</a> in a press conference that the central bank has many more tools in its toolkit, but he also emphasized what it can’t do, in terms of fiscal policy. Fair enough, but markets need to hear what the Fed can and will do, not what it can’t. </p>
<p>Back in 2002, his predecessor Ben Bernanke popularized the idea of “helicopter money,” in which the <a href="https://www.investopedia.com/articles/personal-finance/082216/what-difference-between-helicopter-money-and-qe.asp">Fed supplies large amounts of cash</a> to the public directly, “as if the money was being distributed or scattered from a helicopter.” Bernanke never did it, but maybe Powell will need to. </p>
<p>During the global financial crisis, the U.S. government <a href="https://www.investopedia.com/terms/s/stimulus-check.asp">did send out checks</a> to regular people to help stimulate the economy, but this ultimately added to the deficit. The difference with the Fed doing something like this is that it <a href="https://www.brookings.edu/blog/ben-bernanke/2016/04/11/what-tools-does-the-fed-have-left-part-3-helicopter-money/">can “create money</a>” out of thin air, which can lead to inflation but also means it’s virtually unlimited. </p>
<h2>Show us the money</h2>
<p>Of course, Fed can’t end a public health crisis with a wave of its hand. No matter what it does, the pandemic will take time to abate, perhaps depending on how well Americans follow the advice of public officials and <a href="https://www.politico.com/news/2020/03/15/fauci-warns-spike-coronavirus-deaths-130162">hunker down</a>.</p>
<p>And Powell was right: The Fed alone can’t prevent or stop a recession. Whether anyone can do so at this point is debatable, but at the very least, government stimulus of some magnitude will certainly be needed to contain the damage – and more than <a href="https://www.nytimes.com/2020/03/13/us/politics/trump-coronavirus-relief-congress.html">is currently being considered</a>. </p>
<p>But the Fed can – and must – find a way to reassure financial markets and stop the panic before it gets out of hand, even if stocks continue to decline as we learn more about the extent of the outbreak in the U.S. </p>
<p>Put another way, Powell needs to “show us the money.”</p>
<p>[<em>Deep knowledge, daily.</em> <a href="https://theconversation.com/us/newsletters?utm_source=TCUS&utm_medium=inline-link&utm_campaign=newsletter-text&utm_content=deepknowledge">Sign up for The Conversation’s newsletter</a>.]</p><img src="https://counter.theconversation.com/content/133739/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Alexander Kurov does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>The Fed slashed interest rates to near zero but, just as in 2008, it will require unprecedented action to calm panicky markets.Alexander Kurov, Professor of Finance and Fred T. Tattersall Research Chair in Finance, West Virginia UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1235602019-09-17T20:18:18Z2019-09-17T20:18:18ZWall Street is ignoring the omens of recession – here’s why<figure><img src="https://images.theconversation.com/files/292871/original/file-20190917-19083-1xltqir.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Why is this man smiling?
</span> <span class="attribution"><a class="source" href="http://www.apimages.com/metadata/Index/Financial-Markets-Wall-Street/ed7d188d87344e5caab8c8aa639a2dfb/21/0">AP Photo/Richard Drew</a></span></figcaption></figure><p>The world is on the <a href="https://www.cnn.com/business/live-news/recession-fears-august-2019/index.html">brink of a recession</a>, if all the <a href="https://www.businessinsider.com/next-recession-credit-investor-fears-at-record-high-baml-survey-2019-9">breathless</a> <a href="https://fortune.com/2019/09/11/is-recession-coming-us-manufacturing-trump-country/">headlines</a> are to be <a href="https://www.cnn.com/2019/09/06/business/recession-yield-curve-ny-fed/index.html">believed</a>. So why are U.S. stocks near all-time highs?</p>
<p>That’s a question my <a href="http://www.bu.edu/questrom/">MBA students</a> have been asking me lately. Even the Federal Reserve is concerned – at least <a href="https://www.bloomberg.com/news/articles/2019-09-18/fed-makes-second-straight-rate-cut-splits-on-further-action?srnd=premium">worried enough</a> to reduce U.S. borrowing costs for the second time this year. </p>
<p>Stocks are <a href="https://www.investopedia.com/investing/why-do-companies-care-about-their-stock-prices/">usually considered a barometer</a> of a company’s future prospects, so rationally you’d think market prices would be a lot lower if a <a href="https://www.cnbc.com/2019/09/11/trump-approval-rating-on-the-economy-falls-during-recession-fears.html">recession were close at hand</a>. After all, recessions are a drop in economic activity, which means consumers and businesses are buying less stuff. </p>
<p>The answer to <a href="http://businessmacroeconomics.com/">my students’ question</a> has a lot to do with profits and interest rates, but also “animal spirits.”</p>
<h2>Moving in mysterious ways</h2>
<p>Both the <a href="https://www.bloomberg.com/quote/INDU:IND">Dow Jones Industrial Average</a> and the <a href="https://www.bloomberg.com/quote/SPX:IND">Standard & Poor’s 500</a>, Wall Street’s two main gauges for the U.S. economy, hit record highs in July and have been hovering near them ever since. </p>
<p>At the same time, <a href="https://theconversation.com/how-to-invest-if-youre-worried-a-recession-is-coming-122003">signs</a> of <a href="https://theconversation.com/how-to-invest-if-youre-worried-a-recession-is-coming-122003">trouble</a> for the global economy – and the U.S. – <a href="https://markets.businessinsider.com/news/stocks/baml-fund-manager-survey-finds-fears-of-recession-at-highest-since-2009-2019-9-1028529820">have been growing</a>. By Deutsche Bank’s reckoning, U.S. stocks <a href="https://www.marketwatch.com/story/the-sp-500-should-be-13-lower-because-a-recession-is-coming-warns-deutsche-bank-2019-09-17">should be 13% lower</a> than they are today. </p>
<p>But understanding exactly why stock markets move up or down is exceptionally difficult. </p>
<p>One of the greatest economists of all time, John Maynard Keynes, believed there were “<a href="https://www.economist.com/media/pdf/animal-spirits-akerloff-e.pdf">animal spirits</a>” – essentially, emotions, instincts and other unquantifiable human behavior – that drove people to waves of optimism or pessimism, as he explained in his 1936 book “<a href="https://www.palgrave.com/gp/book/9783319703435">The General Theory of Employment, Interest and Money</a>.”</p>
<p>Keynes believed these “spirits” had a huge influence on financial market prices and conditions. But beyond these mysterious movements there are two primary factors that push overall stock prices up and down: profits and interest rates.</p>
<h2>Profit sharing</h2>
<p>The value of a public company and its shares is based on its profits. </p>
<p>Profits are just the difference between a business’s sales and its costs. Buying shares in a company gives the buyer a claim on a portion of these profits. During an economic expansion, <a href="https://hbr.org/2019/04/companies-need-to-prepare-for-the-next-economic-downturn">profits go up</a>. During a recession, profits for most companies go down.</p>
<p>Stock prices are directly related to profits because when profits rise companies have more money to give out to shareholders in dividends. This makes stocks more valuable. </p>
<p>Rising profits also mean companies have <a href="https://www.cnn.com/2019/07/30/investing/stock-buybacks-debt-leverage/index.html">more money to buy back their own shares</a>, which leaves fewer available on the open market. This reduction pushes stock prices up because each one now gets a slightly larger share of profits. </p>
<p>The impact of a share buyback is no different from what happens when any kind of product becomes hard to find. Sellers see lots of demand while they have relatively little product to supply. To balance this excess demand, they raise prices.</p>
<p><a href="https://www.cbsnews.com/news/heres-the-most-recent-sign-the-economy-is-headed-for-recession/">During recessions, companies’ profits fall</a>. Less profit means lower dividends and less money for share buybacks. Both of these reduce share prices since there is less incentive to invest.</p>
<figure class="align-center ">
<img alt="" src="https://images.theconversation.com/files/292870/original/file-20190917-19040-366mx2.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/292870/original/file-20190917-19040-366mx2.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=400&fit=crop&dpr=1 600w, https://images.theconversation.com/files/292870/original/file-20190917-19040-366mx2.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=400&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/292870/original/file-20190917-19040-366mx2.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=400&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/292870/original/file-20190917-19040-366mx2.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=503&fit=crop&dpr=1 754w, https://images.theconversation.com/files/292870/original/file-20190917-19040-366mx2.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=503&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/292870/original/file-20190917-19040-366mx2.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=503&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
<figcaption>
<span class="caption">Federal Reserve Chair Jerome Powell has been easing monetary policy in recent months.</span>
<span class="attribution"><a class="source" href="http://www.apimages.com/metadata/Index/Global-Economy/49214b2c4de642cbb327f48044701425/171/0">AP Photo/Kiichiro Sato</a></span>
</figcaption>
</figure>
<h2>The impact of interest rates</h2>
<p>The connection between profits and stock market prices is fairly easy to understand. Interest rates, on the other hand, are a bit less straightforward but are just as potent at driving stock prices. </p>
<p>In simple terms, stock prices are inversely related to interest rates. When interest rates fall, <a href="https://www.investopedia.com/investing/how-interest-rates-affect-stock-market/">stock prices usually go up</a>. And when rates rise, stock prices tend to fall.</p>
<p>Interest rates have this effect because <a href="https://www2.deloitte.com/us/en/insights/economy/issues-by-the-numbers/rising-corporate-debt-levels.html">many companies borrow money</a> to operate their business. When interest rates fall, it costs less to run the company since businesses pay less to service their debts, boosting profits. On the other hand, when rates rise, costs go up, squeezing corporate earnings. </p>
<p>Lower interest rates also boost the share prices of companies that don’t borrow money because they <a href="https://www.investopedia.com/calculator/pvcal.aspx">increase the present value</a> of their future profits. This is why money earned tomorrow is worth less than money earned today. </p>
<p>The simplest way to see this is to imagine <a href="https://theconversation.com/how-winning-1-54-billion-in-mega-millions-could-still-lead-to-bankruptcy-105275">winning a million dollars</a> right now. You’d be a lot less thrilled, however, if you were told you wouldn’t receive a dime for 25 years. And so lotteries typically let winners <a href="https://theconversation.com/got-the-winning-lottery-ticket-an-economist-explains-what-to-do-with-all-that-money-105700">take a greatly reduced lump sum</a> immediately or receive the total in smaller payouts over many years. </p>
<p>It’s the level of interest rates that determine just how much future income is worth today. Higher rates reduce the value of future prizes and profits; lower rates increase it. </p>
<h2>What occupies Wall Street</h2>
<p>To understand why stocks keep going up, we have to consider what profits and interest rates are doing, and what Wall Street traders are focused on. </p>
<p>Corporate profits, which have been <a href="https://www.bloomberg.com/opinion/articles/2019-09-01/corporate-profits-are-down-but-wages-are-up">hitting their own record highs</a> in recent years, <a href="https://www.cbsnews.com/news/heres-the-most-recent-sign-the-economy-is-headed-for-recession/">are currently stagnating</a> and are forecast to dip as a result of the <a href="https://www.thestreet.com/markets/rates-bonds/chart-corporate-profits-are-stagnating-15088966">trade war</a>. </p>
<p>However, central bankers around the world are also worried about a recession. They are working hard to prevent this recession by driving down interest rates now. For example, the European Central Bank on Sept. 12 <a href="https://www.nytimes.com/2019/09/12/business/ecb-europe-recession-stimulus.html">cut a key interest rate</a> and took other steps to ease borrowing costs for companies and businesses. And the <a href="https://www.wsj.com/articles/powell-set-to-address-economic-outlook-ahead-of-fed-meeting-11567762202">Fed followed suit</a> on Sept. 18 with a quarter-point reduction. </p>
<p>Lower interest rates encourage consumers, businesses and governments to borrow and spend more money – and boost the value of stocks. Although some investors are concerned about a recession, apparently most believe actions by the Fed and other central banks will be enough to keep the global economy humming – or at least enough to keep corporate profits high. </p>
<p>How long will the rising stock market continue? Who knows. But that’s what makes following financial markets so interesting for academics and so frustrating for individual investors.</p>
<p>[ <em>Deep knowledge, daily.</em> <a href="https://theconversation.com/us/newsletters?utm_source=TCUS&utm_medium=inline-link&utm_campaign=newsletter-text&utm_content=deepknowledge">Sign up for The Conversation’s newsletter</a>. ]</p><img src="https://counter.theconversation.com/content/123560/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Jay L. Zagorsky does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>An economist unravels the seeming contradiction between stocks flirting with all-time highs and growing fears of a recession.Jay L. Zagorsky, Senior Lecturer, Boston UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/909932018-03-19T10:38:52Z2018-03-19T10:38:52ZYou’re probably paying more for your car loan or mortgage than you should<figure><img src="https://images.theconversation.com/files/210885/original/file-20180317-104694-1n1y2o7.gif?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">A bad interest rate can make your new car a lot more costly.</span> <span class="attribution"><span class="source">AP Photo/Carlos Osorio</span></span></figcaption></figure><p>The Federal Reserve makes headlines from New York to Hong Kong anytime it lifts its benchmark interest rate. Rightfully so, as any increase tends to drive up <a href="https://www.nytimes.com/2017/12/13/business/fed-rate-mortgages-loans-credit.html">borrowing costs</a> on everything from credit cards to auto loans and mortgages.</p>
<p>There’s a more important factor that determines how much you’ll pay when you borrow money to buy a car or home, and it’s entirely in your hands: the lender you choose. That’s because how much a lender might charge you for a loan can vary dramatically from one to the next. That’s why it pays to shop around. </p>
<p><a href="https://scholar.google.com/citations?user=OOrSzlkAAAAJ&hl=en&oi=sra">My</a> <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3044889">research on auto loans shows</a> that most consumers don’t do that, which can cost them hundreds or even thousands of dollars over the life of a loan or lead them to purchase a lower-quality car than initially planned. Fortunately, it’s pretty easy to avoid that.</p>
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<h2>Bargain hunters</h2>
<p>Most of us shop until we drop for price bargains on clothes, computers or virtually anything else. With the internet, finding the best deal among products and companies is easier than ever.</p>
<p>A <a href="https://www.multivu.com/players/English/8181551-hawk-incentives-deal-seeking-shoppers/">recent survey</a> found that 92 percent of consumers always look for the best deal when they’re out shopping, while 80 percent said they’re willing to go out of their way to find a bargain. </p>
<p>So you’d think this logic would carry over to the bigger purchases in life. For most Americans, automobiles are the <a href="https://scholar.harvard.edu/files/campbell/files/householdfinance_jof_2006.pdf">largest- or second-largest household asset</a> they own. And <a href="https://www.yahoo.com/news/consumers-rely-car-financing-more-ever-203000128.html">most cars</a> are purchased with the help of an auto loan.</p>
<p>And yet, while people often work hard to find the best possible deal on the price of a car, surprisingly most fail to shop around at all for interest rate bargains. Research shows this behavior isn’t limited to just auto loans – most people don’t shop around when taking out a <a href="https://www.consumerfinance.gov/about-us/blog/nearly-half-of-mortgage-borrowers-dont-shop-around-when-they-buy-a-home/">mortgage</a> or a <a href="http://www.bain.com/publications/articles/tapping-latent-demand-in-personal-lending.aspx">personal loan</a>. </p>
<p>And that’s even though financing costs for a typical loan can make up a significant proportion of the total cost of buying a car. For example, let’s assume you’re buying a US$25,000 car and financing the entire purchase. A $25,000 loan at a 4 percent rate would cost you $2,600 in interest over its life, adding more than 10 percent to the true price of the car. </p>
<h2>What makes a rate</h2>
<p>Let me explain how a lender arrives at a particular interest rate. </p>
<p>The lender usually starts with a benchmark rate, such as the <a href="https://www.bankrate.com/rates/interest-rates/prime-rate.aspx">prime rate</a> or even a U.S. Treasury bond, both of which tend to move up and down along with the Fed’s target rate. </p>
<p>Other variables that go into the rate you ultimately pay include borrower-specific risks like credit scores or your debt-to-income ratio and the lender’s markup, which can be influenced by a variety of factors. For secured loans, such as mortgages and auto loans, the size of the down payment and the value of the asset will make a difference. </p>
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<p>Not all lenders will price the same loan, for the same borrower, the same way. In fact, a bit more than half of all borrowers overpay on their car loans. </p>
<p>That’s the surprising conclusion of a <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3044889">recent study</a> I conducted with Brigham Young finance professors <a href="https://sites.google.com/site/bronsonargyle/">Bronson Argyle</a> and <a href="http://taylornadauld.com/">Taylor Nadauld</a>. We arrived at our findings, after reviewing anonymized data provided by software-services firm <a href="https://www.visibleequity.com">Visible Equity</a> on more than 2 million auto loans extended by 326 different financial institutions.</p>
<p>The data allowed us to compare interest rates on car loans that originated in the same metropolitan area and time period for similar amounts on similarly priced cars and to borrowers with similar credit attributes. </p>
<p>We found that almost 1 in 5 consumers take out a loan more than 2 percentage points higher than the best rate available to people with similar credit scores. </p>
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<p>For example, Mark from Nashville with a <a href="https://www.myfico.com/credit-education/credit-scores/">credit score</a> of 711 agreed to pay a rate of 5.85 percent to buy a used 2012 Toyota Camry for $18,033 — which was the average loan size in our study. A different bank in the area, however, offered Jamie a rate of 4.2 percent for roughly the same loan, even though she had the same credit. In other words, Mark will end up overpaying by about $1,000 over the life of the loan, or about $17 every month. </p>
<p>Contrast that with the likely consequence of the Fed raising rates by a quarter point this month, which would have much less impact on your cost to get a loan. If an auto loan were to go up by 0.25 percentage point, monthly payments on that typical car loan would rise by just $2 a month, or $120 over five years.</p>
<p>Further, we found that many car buyers who end up overpaying cope by buying older, cheaper cars rather than shop around for a better interest rate. Had the borrower shopped around for a better rate, he could have spent most of that $1,000 in extra financing on a higher-quality car. </p>
<p>The same lessons apply to other loans too. A <a href="https://www.consumerfinance.gov/about-us/blog/nearly-half-of-mortgage-borrowers-dont-shop-around-when-they-buy-a-home/">government survey</a> found that failing to shop around for the best mortgage rate could easily cost you $3,500 over just the first five years of the loan and thousands more over the typical mortgage. </p>
<h2>Why people don’t shop for loans</h2>
<p>What accounts for this apparently lackadaisical attitude toward interest rate shopping?</p>
<p>Applying for credit often involves paperwork, which can be tedious or stressful. It could require a trip to a separate lender’s office when buying a car is time consuming enough. Borrowers may not even know that there are better deals to be had. </p>
<p>In fact, we found that a consumer needs only to shop around for three offers to get something pretty close to the best available rate. </p>
<p>Other faulty assumptions may be at play, too, including the notion that you have to finance your car through the dealer (you don’t), that your own bank will give you the best deal (often not, according to our data), that the dealer’s rate will be best (not always), or that your credit score will be affected if you apply multiple places (<a href="https://blog.equifax.com/credit/will-interest-rate-shopping-hurt-my-credit-score/">it won’t</a>). </p>
<p>Part of the problem also seems to be that consumers often <a href="https://www.forbes.com/2009/03/19/credit-poor-judgement-markets-tim-harford.html#7a237e67636c">don’t appreciate the power of compound interest</a> and the extent to which small differences in monthly payments add up.</p>
<p>Admittedly, it’s not as exciting to shop for a loan as it is to test-drive a car, but most of these factors can be overcome or shouldn’t be a concern in the first place. While it does take a little more work to seek out other financing options, modern tools make it easier than you might think. Much of the same financial paperwork can be used at multiple lenders, and websites like <a href="http://bankrate.com">Bankrate</a>, <a href="http://creditkarma.com">Credit Karma</a> and <a href="http://nerdwallet.com">NerdWallet</a> allow you to compare multiple interest rate offers.</p>
<p>The bottom line: Car buyers are literally paying more for less by not doing their due diligence to find the best financing deals. When it comes to credit, it pays to shop around.</p><img src="https://counter.theconversation.com/content/90993/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Christopher Palmer does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Most of us bargain hunt when shopping for a new blouse or pair of blue jeans, yet for some reason we don’t with interest rates, potentially costing us thousands of dollars.Christopher Palmer, Assistant Professor of Finance, MIT Sloan School of ManagementLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/924712018-03-19T10:38:10Z2018-03-19T10:38:10ZRecent stock market sell-off foreshadows a new Great Recession<figure><img src="https://images.theconversation.com/files/210667/original/file-20180315-104676-j2vnia.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">An ice sculpture titled 'Main Street Meltdown' melts near Wall Street.</span> <span class="attribution"><span class="source">AP Photo/Frank Franklin II</span></span></figcaption></figure><p>In early February, concerns about inflation and rising interest rates sent global financial markets into a frenzy, <a href="https://www.npr.org/sections/thetwo-way/2018/02/05/583325123/stocks-extend-losses-with-dow-dropping-more-than-300-points-at-the-open">prompting the biggest single-day drop</a> ever in the Dow Jones Industrial Average. Stocks have since recovered some of their losses.</p>
<p>A similar episode occurred exactly 10 years earlier, <a href="https://blogs.cfainstitute.org/investor/2017/01/31/the-ars-debacle-the-forgotten-crisis-of-2008/">though few may remember</a>. In February 2008, the failure of an obscure market precipitated a <a href="https://blogs.cfainstitute.org/investor/2017/01/31/the-ars-debacle-the-forgotten-crisis-of-2008/">similar selling frenzy</a>. At the time, this sell-off went mostly unrecognized as a harbinger of something worse because the stock market quickly recovered. </p>
<p>Just as the world shouldn’t have been complacent in 2008, we shouldn’t rest easy today. Both events are proverbial dead canaries in a coal mine. </p>
<p>That’s because they have something else in common. Both stemmed from worries that rising borrowing costs would hurt debt-burdened consumers, the housing market and ultimately the U.S. economy.</p>
<p>Our soon-to-be-published research shows that the same problems that led to the biggest financial market meltdown since the Great Depression are alive and well today. </p>
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<h2>2008’s canary in a coal mine</h2>
<p>In the mid-2000s, the U.S. economy <a href="http://www.washingtonpost.com/wp-dyn/content/article/2007/01/31/AR2007013100422.html?referrer=email">seemed to be riding high</a>, but two key problems lurked below the surface: excessive household debt and a housing bubble.</p>
<p>Part of the first problem was that real, <a href="https://fred.stlouisfed.org/series/MEHOINUSA672N">inflation-adjusted household incomes were actually lower</a> than they had been in the late 1990s. To maintain living standards, Americans took on more debt thanks to <a href="https://fred.stlouisfed.org/series/FEDFUNDS">relatively low borrowing costs</a> and weak underwriting standards among lenders. <a href="https://www.newyorkfed.org/microeconomics/hhdc.html">Total household debt soared</a> more than 50 percent, from a little over US$8 trillion in 2004 to $12.69 trillion by 2008. </p>
<p>That brings us to the second problem. Most of that was mortgage debt. The housing bubble pushed it to the point <a href="http://www.jchs.harvard.edu/sites/jchs.harvard.edu/files/son2008.pdf">that it was unsustainable</a> as housing prices outstripped incomes, leading banks to come up with <a href="https://www.theguardian.com/business/2007/sep/30/5">ever creative ways</a> to lend people money they ultimately couldn’t pay back. </p>
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<p>At around the same time, the Federal Reserve began to lift interest rates, from 2004 to 2006, making credit more expensive. This reduced consumer spending as more of households’ falling real incomes went to repay debt, thus <a href="https://fred.stlouisfed.org/series/GDP">slowing economic growth</a> and the housing market. </p>
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<p>To <a href="http://keenomics.s3.amazonaws.com/debtdeflation_media/2007/03/SteveKeenDebtReportNovember2006.pdf">some observers</a>, it was only a matter of time before an economic recession or worse. </p>
<p>Among the first significant signs that things were seriously amiss came from the <a href="http://www.mondaq.com/unitedstates/x/60418/securitization+structured+finance/AuctionRate+Securities+Bidders+Remorse+A+Primer">auction rate securities</a> market, which was worth about $330 billion at its peak in 2008. Auction rate securities are essentially packages of mortgages, student loans and other medium- to long-term debt. Back in 2008, broker dealers held weekly <a href="https://www.investopedia.com/terms/d/dutchauction.asp">Dutch auctions</a> at which these short-term securities changed hands and interest rates were set after a bidding process. <a href="https://www.barrons.com/articles/SB121159302439419325">Credit-rating agencies gave them</a> their <a href="https://www.investopedia.com/terms/a/aaa.asp">super-safe ranking of AAA</a>. </p>
<p>Investors <a href="https://blogs.cfainstitute.org/investor/2017/01/31/the-ars-debacle-the-forgotten-crisis-of-2008/">liked them</a> because they were paid a much higher rate than other short-term securities with AAA ratings. Because they could be sold quickly to investors, borrowers could get loans more easily. </p>
<p>But on Feb. 7, 2008, the <a href="https://fas.org/sgp/crs/misc/RL34672.pdf">market began to seize up</a>. It started when the big investment banks, responsible for ensuring the market had plenty of “liquidity” by purchasing the securities if demand was weak, backed away because a growing number of households couldn’t repay their debts and this was beginning to squeeze their bottom lines. </p>
<p>This spooked investors, who sensed something was wrong. By the end of the month, there were no auctions, and billions of dollars in securities were frozen. The auction rate securities market remains closed to this day. </p>
<p>Within months of its February seizure, the broader market had moved on, as the Dow Jones Index reached the year’s peak by May. Yet the event sent ripples throughout the economy as investors continued to avoid mortgage-related assets. </p>
<p>By September 2008, when investment bank Lehman Brothers collapsed because of problems with these securities, the Great Recession was in full swing. </p>
<h2>Deja vu?</h2>
<p>Fast forward to today. </p>
<p>The economy has mostly recovered from the financial crisis, the <a href="https://data.bls.gov/timeseries/LNS14000000">unemployment rate has dropped</a> from 10 percent in 2009 to 4.1 percent in January and <a href="https://fred.stlouisfed.org/series/MEHOINUSA672N">real median household income surged</a> to a record at the end of 2016. </p>
<p>Good news, right? </p>
<p>Our new research shows that these rosy-looking stats conceal the same two related problems as 10 years ago: excessive consumer debt (relative to income) and unaffordable housing.</p>
<p>First, debt and income. After falling in the aftermath of the Great Recession, debt is once again reaching new highs. Especially worrisome, nonmortgage household debt (student loans and credit cards) has soared at a rapid pace and <a href="https://www.newyorkfed.org/microeconomics/hhdc.html">is now 41 percent above</a> its previous peak in 2008. We estimate that the resulting interest payments on nonmortage household debt have reduced living standards of the typical household by 3.1 percent since 2008. That either lowers consumption or prolongs the vicious cycle of more and more household debt. </p>
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<p>But things are even worse than this. Income data ignore <a href="http://www.pewresearch.org/fact-tank/2017/05/05/its-becoming-more-common-for-young-adults-to-live-at-home-and-for-longer-stretches/">recent demographic shifts</a>, such as more multi-generation households and college students living with their parents longer. We adjusted household income by family size because more people living together requires more money to attain the same living standards. Our data show this has lowered average living standards by 3.3 percent. This is on top of the 3.1 drop due to greater interest payments on nonmortgage debt.</p>
<p>Second, although there is no great housing bubble today, the fundamental problem is the same as 10 years ago – people with average incomes cannot afford to buy and live in an average priced home. Low interest rates helped the housing market recover, but <a href="https://www.usatoday.com/story/money/2017/07/25/u-s-home-prices-reach-record-high-6th-straight-month/507808001">also helped drive prices to record highs</a>. </p>
<p>Just like before the 2008 crisis, incomes <a href="https://www.cnbc.com/2018/03/13/economist-home-prices-are-increasing-twice-as-fast-as-income-growth.html">have not kept pace</a> with home prices. Too many people cannot afford to buy a home. </p>
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<span class="caption">Dark days ahead?</span>
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<h2>Storm clouds brewing</h2>
<p>So what does this all mean? </p>
<p>Home prices and consumer debt are again at record highs, and the Fed has been steadily raising benchmark borrowing costs for over a year now. The central bank <a href="https://www.cnbc.com/2018/01/30/fed-will-be-forced-to-raise-rates-more-rapidly-than-expected-cnbc-fed-survey.html">is expected</a> to accelerate the process because the recent tax cut is likely to cause inflation to rise, requiring the Fed to lift interest rates to cool things down. This will hurt the housing market, pushing more homeowners underwater and making it harder for them to pay their mortgages and repay other debt.</p>
<p>At the same time, incomes have only grown modestly and, as our research shows, average American households have 6 percent to 7 percent less spending power than they did a decade ago, before the global financial system collapsed. Something will have to give. Households can take on more debt to maintain their living standards for a short while, or they can significantly reduce their spending. </p>
<p>In either case, the U.S. economy is primed for another recession. We believe it’s not a question of if. It’s a question of when.</p><img src="https://counter.theconversation.com/content/92471/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>The authors do not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and have disclosed no relevant affiliations beyond their academic appointment.</span></em></p>The collapse of an obscure corner of the financial market a decade ago foreshadowed the Great Recession. The stock-market swoon in February should offer a similar warning.Steven Pressman, Professor of Economics, Colorado State UniversityRobert H. Scott III, Professor of Economics & Finance, Monmouth UniversityLicensed as Creative Commons – attribution, no derivatives.