Today in 2015
Interest rates have been kept at record lows for 7 years now, but how long can it last? The main reason for raising interest rates is to combat inflation and prevent the economy from overheating during periods of strong economic growth. Donovan has mentioned that this interest rate rise is long overdue, which could become a worry if inflation continues to pick up. That is why the Fed has expect to raise interest rates when it believes that the U.S. economy can now survive on its own without any stimulus.
“Yellen has always said that they will raise interest rates when wages go up between 4 and 5 percent” Paul Donovan, a global economist at UBS investment bank told CNBC with reference from the U.S. labour department that wages and salaries are now growing at 4.2 percent year on year. As The Fed would not want to forestall its recovery by prematurely increasing interest rates, it has been rumoured that there would be two interest rate hikes, resulting in a very gradual and gentle curve.
So what happens if interest rates do go up? The question is how much would they increase; will it have more effect on long or short term rates, and how fast will it happen? While we cannot stop the interest rate hike from happening, we can however, prepare for it, especially for business owners.
Mortgage rates will increase
Since mortgages are used by individuals and businesses to make large real estate purchases without having to pay the entire value of the purchase up front, the borrower often has to repay the loan with interest over a period of time until he/she eventually owns the property. Mortgage rates then come primarily in two forms, fixed rate and adjustable rate, with some hybrid combinations and multiple derivatives of each. As the Fed indicated its intention to raise rates, borrowers have been rushing to get deals done now to lock in lower interest rates. This means that the borrower can pay the same interest rate for the life of the loan. Dean Croushore, an economist professor at the University of Richmond and former Philadelphia Fed economist, has also advised that people thinking of buying a house should act quickly to lock in today’s lower rates.” Experts have also supported that mortgage rates and auto loans will increase once rates raises.
Real Estates and Property prices
If interest rates were to increase, investors would definitely demand higher returns on assets. If rents were to remain the same, it would lead to a fall in asset prices due to lower property value. It is unclear as to whether rents would remain the same or otherwise, however we know that higher interest rates means that buying a home becomes more expensive. If it therefore pushes prices too high where it becomes difficult to afford, asking prices may still have to come down. Nonetheless, Mark Goldman, a C-2 Financial loan officer and a real-estate lecturer at San Diego State University and Lynn Reaser, a chief economist at Point Loma Nazarene University have supported that this would however not stop property prices from appreciating.
Cost of Borrowing
Ted Peters, CEO of Bluestone Financial Institution Funds and a former member of the Federal Reserve Bank of Philadephia said that “An increase rate increase will cause the borrowers to be the losers and the savers to be the winners.” Indeed, a rise in interest rates often encourage savers/lenders as this means they can now earn higher interest if they were to put their money in the bank. In contrast, this also means to borrowers that the cost of borrowing has also risen where it becomes more expensive to borrow money. For people who already have existing loans, disposable income is highly likely to fall as they spend more on interest payments. Hence, investments as well as the marginal propensity to consume may fall as well.
Effect on Prices/Disinflation?
Although a business costs may increase due to an increase in cost, it is solely dependent on business owners to access whether they should pass some or all of that cost to customers. Nonetheless, increased interest rates implies that consumers have less money to spend. With less spending, the economy would theoretically slow down and decreases inflation. The overall effect on prices will depend on whether the goods and services offered by producers are inelastic or elastic to consumer demand.
Savings and Investments
While an increase in interest rates would mean higher yields, bond prices is going to fall due to an inverse relationship. Investors holding bonds may expect to see their portfolio decrease in value. This could also imply that with an improved U.S. economy, investors may want to allocate some of their funds to equities to enjoy more protection for better returns. It may be more advisable to adjust from sectors which are more inelastic to the interest rate hike, such as energy, utilities and food etc. as these sectors have lesser reliance on consumers’ disposable income.
Only a Matter of Time
Higher interest rate would likely cause the US dollar to appreciate as there would be a capital influx in US banks if their rates are higher than other countries. A higher US dollar makes their exports less competitive which would eventually affect their aggregate demand in the economy. Higher interest rates tend to reduce many factors associated in the Aggregate Demand equation which may result in lower economic growth. Besides, the effect of rising interest rates can often take up to 18 months to feel the impact, hence it is likely that people can have time to adjust and prepare for it. The U.S. economy is on its way to stand on its own and it is highly likely that The Fed would not want to forestall its recovery by prematurely increasing interest rates.
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