Higher Interest Rates: the Good, the Bad, and the Ugly

Higher Interest RatesThe U.S. Federal Reserve has kept interest rates artificially low in order to stabilize the economy downturn of 2008 and 2009. Is it about time the Federal Reserve raises interest rates? Can our economy handle it?

You see, under low interest rates, consumers and firms find it easier to borrow money to finance their spending, investment, and operations. Lower interest rates also make stocks and real estate more attractive because the return on saving money (interest) has gone down.

Mind you, it’s not all positive under low interest rates; returns on investments that pay a fixed interest rate (such as certificates of deposit) have plunged. This means retirees are earning ultra-low returns on their hard-earned savings. Once growth is back on track, the Federal Reserve will increase interest rates to deal with inflation.

Can the U.S. Economy Handle Higher Interest Rates?

One of the benefits of lower interest rates is that borrowing is cheap. As a result, people find it easier to get a mortgage and buy a house. The housing market should do well under the low cost of borrowing. Let’s look at the Case-Shiller 20-City Composite Home Price Index; although home prices have rebounded from the lowest level during the recession, they are still around 15% lower than the pre-recession high. Increasing interest rates means higher mortgage rates. This will no doubt put pressure on the housing market through homeowners and potential buyers facing an increased cost of borrowing. (Source: Federal Reserve Bank of St. Louis, April 28, 2015).

It‘s not just the homeowners who are affected by higher interest rates. The average U.S. household has $15,611 in credit card debt, $155,192 in mortgage debt, and $32,264 in student loan debt. Increasing the annual interest rate by just one percent means the average U.S. family would spend $2,030.67 more per year on interest payments. Would that be a good thing? Of course not. (Source: Nerd Wallet, April 28, 2015.)

What about inflationary pressures? Our economy is growing and the Fed need to raise interest rates to control inflation, right?

Wrong. We are still not recovered from the crisis. And raising interest rates doesn’t help. The March jobs report was very disappointing. We added the least amount of jobs since December 2013. And those jobs that were added are mainly in low-paying sectors such as retail sales and restaurants. We actually lost 11,000 jobs in mining, with no improvement in other skilled labor sectors.

Moreover, underemployment is still pervasive; there are 6.7 million people in the U.S. that want to work full time, but who can only work part time, because that’s more readily available. Stagnant wages and shorter hours impose constraints on people’s income. When we do not have growth in our disposable income, people may need to borrow money to finance spending on cars, houses, and education. Higher interest rates would not help here.

At a national level, the lack of growth in our income means total consumption cannot grow. Two-thirds of U.S. gross domestic product (GDP) comes from consumption. Stalling consumer spending will hinder overall GDP growth.

Higher Interest Rates to Tame Inflation?

The main reason for raising interest rates is to control inflation. Currently, the annualized monthly inflation rate is -0.09%, -0.03%, and -0.07% for January, February, and March of 2015, respectively. This is deflation; meaning price levels are actually dropping. (Source: Bureau of Labor Statistics, April 28, 2015.)

The Federal Reserve considers this abnormal situation a consequence of tanking oil prices. They argue that focusing on the long run, there will be inflation. And they are prepared to fight it by raising interest rates in the future.

Looking at historical inflation rates, the Fed should not be worried. Growth during the past several years did not bring much inflationary pressure: the Consumer Price Index (CPI) went up by 1.6% in 2014 and 1.5% in 2013, below the Fed’s 2.0% target. As for expected inflation, if you look at the growth prospects I just described, you wouldn’t be too worried about prices going up.

With sluggish growth in our labor market and consequently our GDP, the U.S. economy can’t really afford higher interest rates.

On the Upside, Higher Rates Will Cool the Stock Market Bubble

There are some positives to higher interest rates. For example, since March 2009, the S&P 500 has soared 215%. There are some who believe the stock market is fairly valued. Most analysts think the six-plus-year bull market is sorely overvalued.

For example, according to the CAPE ratio, the S&P 500 is overvalued by 70%. The only other times the ratio has been above this level were in 1929 and 1999. Rising interest rates will make borrowing more expensive and should help cool down the bloated bull market.

Moreover, if the interest rates rise in a moderate fashion, then this will not have a catastrophic effect on consumer borrowing rates in the short term. In the longer term, those rates could add up to a detrimental effect on cash-strapped Americans.

Only time will tell.