Economy Today: Will the Fed raise interest rates?

Lea este artículo en español

We have a week of bear stock markets (that means that the prices of stocks are going down and people are selling their sticks) as there is speculation –read this article to learn what speculation is- of a possible early rate hike in interest rates from the Federal Reserve as early as June.

That’s a big statement there. So today I am going to explain what an interest rate change from the Fed is, and what it means for you, for the government, and for the economy of the United States at large.

I explained before that, as part of its monetary policy, central banks (in this case the Federal Reserve) control the interest rates with the purchase and sale of debt, treasure bills, notes, and bonds.

Janet Yellen, Chairwoman of the
Board of Directors of the Federal
Reserve System

The last few years the Fed has kept rates low to keep more money in circulation and promote economic growth. It has been working, unemployment is down, and all economic indicators show that the United States economy is picking up momentum. Recovery is on its early stages but it seems a pretty sure thing right now.

When rates are low, the price of borrowing is low, which leads to businesses taking out loans, which in turn results in businesses having more money to produce more, which leads to hiring, and more jobs lead to more consumption… that is a healthy economic cycle. The only problem is that long term low rates lead to inflation. How? the more purchasing power the people have, the more they buy and the more demand there is for products, the higher their prices will go (this is known as the Law of Supply and Demand). So, long term low rates are not desirable either.

This bring us back to the news that the Fed may increase rates, and what it means

For you, the consumer

The increase in rates at the hands of the Fed will not be felt immediately. The real interest rates, which is what we call the interest rates that consumers pay for borrowing money on their credit cards, their car loans, etc., come at a trickle a relative while after the Fed changes the rate. The Fed sells bonds, which financial institutions and corporations buy. That means that those institutions and organizations will have less money, so the price for borrowing from them in turn goes up. Additionally, the Federal Reserve changes the rate (the interbank rate, called the Fed Funds rate in the United States) at which it lends money out on overnight loans to financial institutions that need it. And that is the actual rate change; the price of the Fed’s money goes up. And because banks and financial institutions have to pay more to borrow, we have to pay more to borrow from them. They change the rates they charge you and I, the consumers.

But that is not all. Because financial institutions have less money to work with, it means they want our money now… so the savings accounts interest rates go up. So, even if we have to pay more for borrowing money it is not all bad. If we save, our rewards will now go up too. So, rate increases can be said to promote consumer savings. More savings means we spend less money, which means that the prices of products will go down and thus, reducing inflation. 

For the government

For the government right now a raise in interest rates might not be advisable. While historically when unemployment was low they tried to promote savings, right now the United States government has a staggering amount of debt. The past few years the government has saved money because with rates being so low, repayment of debt was cheap. That was good and it continues to do so, as the government is saving money and its deficit is going down.

But if they increase the rates, that includes what the government pays on its own debts. It is estimated that a rate hike now, calculated over the outstanding debt, would mean that the government would pay between one and two trillion dollars more (on the interest) on its outstanding debts in the first ten years.

Yikes, right? Most economists agree.

If the Fed chooses instead to hold on to the debt, including the 3 trillion of QE purchased mortgage-backed securities (to find out what Quantitative easing is, read this article) and long-term debt that it’s holding, and the rates stay as they are, the budget deficit will continue to go down. The government saves.

For the economy of the United States at large

The Federal Reserve

This is the iffy part of the situation. The worries of experts these days are justified in both directions. On the one side, there seems to be no actual reason to raise the rates as all aggregates and indicators seem strong and there is no inflation.

You see, the value of the dollar abroad, the exchange rate, has been rising; here's a table of the exchange rate between the USD and the Euro in the past year. When the exchange rate of a currency goes up so does its purchasing power, of course. This means that US businesses and consumers can buy more foreign goods (that translates as less demand for domestic goods). However, this rise also means that foreign investors will chose to buy other goods from countries where they are cheaper, because their currencies are lower-valued. That leads to the economic cycle stopping and reversing: no sales equals less money to business, who then have to lay people off, and the economy slows down again.

How can the government lower the price of the dollar? By increasing interest rates, because that causes foreign investors to place their deposits here, since they will get a better return. And the US dollar is rising at a rate that is very worrisome.

It is an interesting conundrum. If the Fed increases rates, it will have a large negative impact on the government budget while increasing consumer savings and foreign investment. If they do nothing, the government saves on its own debt but loses on exports which will lead over time to the stagnation of the economy. Will the Fed be able to figure out the delicate balance point of this very sharp two-sided knife? Let’s wait and see.


Which reminds me: if you live in the United States, now it’s a great time to travel to Europe. Spring is coming and now it’s cheaper!