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Interest Rates, the Economy, and the Financial Markets

June 02, 2016

There has been a lot of talk this week about the effects of an increase in interest rates. The minutes for the April meeting of the Federal Reserve Board Open Market Committee, the Federal Reserve committee that sets short term interest rates, were released on May 18th. Information contained within the minutes showed that the Federal Reserve is seriously considering an additional interest rate hike during their meeting in June. So what would that mean for the economy and the stock market?

Historically, the Federal Reserve raises interest rates when it is concerned about increasing rates of inflation. Higher interest rates are intended to slow the pace of economic growth to keep the economy from “over-heating,” which can lead to inflation. Higher interest rates make it more costly for consumers and businesses to borrow to fund consumer spending and business investment. This reduces demand for consumer goods and services as well as business equipment and labor. In addition, large purchases such as houses and cars become less attractive because higher interest rates will increase the payment required to purchase such high-dollar items. This reduction in demand could be expected to cause economic growth to slow and reduce inflationary pressures.

The financial markets can also be negatively affected by interest rates, as we saw in January and February of this year when the US stock market declined over 12% following a 0.25% increase in short-term interest rates in December. Higher interest rates increase the interest on corporate debt which, all else equal, will reduce corporate profits. Higher interest rates may also reduce corporate stock buy-back activity as it makes it more expensive for companies to borrow money to purchase their own shares. This can reduce a source of demand for stocks which may depress the price or at least limit the rate at which prices are likely to increase. Higher interest rates may also cause a company to invest less money for future growth. As the cost of borrowing increases, some projects that were expected to be profitable at lower interest rates may no longer appear as attractive when higher interest costs are factored in. This can cause companies to pull back on investment spending, which may reduce the rate of future earnings growth.

The bank markets are also negatively affected by interest rates. Typically, as interest rates increase the value of a bond will decrease. The longer term the bond, the greater the decline in value when interest rates rise. However, higher interest rates means that bond interest payments can be reinvested into new bonds with higher yields. Therefore, higher interest rates can be a short-term negative for bonds but a longer-term positive. All else equal, the longer-term the bond, the longer it takes to realize the potential benefits from rising interest rates.

Lastly, higher interest rates can have a negative impact on investment values by increasing the discount rate that is applied to expected future income. When financial analysts value investments they project the future income, such as corporate earnings and dividends or bond interest payments, out into the future. They then discount those payments to determine their present value to calculate how much they are worth in today’s dollars. The higher the discount rate, the lower the present value of a future income. Therefore, higher interest rates may cause financial analysts to reduce their estimated value for investments, including stock, bonds, and real estate.   

The broad-reaching and diverse effects that interest rates can have on the economy and investment markets make them an important factor to consider when planning and implementing an investment strategy. For this reason, the future path of interest rates is never far from the minds of those in the financial media or the investment profession.