How Interest Rates Reflect Economic Uncertainty

With inflation reaching a record year-over-year high of 7.9 percent in February 2022, the U.S. Federal Reserve (the Fed) has decided to combat the situation by raising interest rates. While this strategy generally works to mitigate rising costs and return inflation to a reasonable level, it comes with some downsides.

In this post, we'll look at how the Fed's rate hikes will affect economic uncertainty in the markets. We'll also talk about the impact on everyday financial products, such as credit cards, student loans, and mortgages.

The Stock Market

Generally, when the Federal Reserve raises interest rates, it slows down growth in the economy. This is because the cost of borrowing just became more expensive.

Consider that when companies have to spend more money to get the funding they need, it can cause:

• Decrease in production

• Decrease in profit margins

• Worker lay-offs

While these results are undesirable, they’re unfortunately necessary to accomplish the Fed's ultimate goal of reducing inflation to their targeted rate.

The central bank has to be careful in its rate adjustments because a hike too large could cause these conditions to swing too quickly and throw the entire economy into a recession.

When done strategically, the best-case scenario is that stocks may only dip slightly for a temporary period of time. As the economy begins to stabilize on its own, ideally it can begin to prosper again.

Bond Yields

Typically, investors flock to bonds when there's economic uncertainty as a way to protect their capital. However, they should be cautious since a rising interest rate will cause the coupon rates of previously issued bonds to appear lower and less attractive.

For example, suppose someone invests in a bond with a 3 percent coupon rate. Years later, if interest rates rise and the new coupon rate is 4 percent, then your investment of 3 percent will not be as desirable.

Of course, bond terms vary in length, so this trend wouldn’t continue forever. Shorter-term bonds will begin to mature and then investors will have the opportunity to buy at the higher yields.

Consumer Rates

Even if you're not someone who invests in stocks and bonds, rising interest rates will still likely impact many of the lending and credit products that you regularly need and use.

This is because of something called the prime rate. The prime rate is an internal interest rate that banks use to establish the rates on their financial products to their most creditworthy customers. It's a number that's shared within the banking industry, and this is why consumers may notice that different lenders offer more or less the same rates.

As you might guess, the prime rate is directly tied to the rate set by the Federal Reserve. So every time the Fed raises interest rates, this means that everything from variable credit card interest rates to the competitive rates for student loan refinancing are likely to rise in the coming months.

The Federal Reserve is very transparent about its intentions to raise interest rates. Therefore, if you were planning to apply for a new loan or refinance an existing one, timing is critical. Based on the Fed’s shared plans for rate hikes, your consumer interest rate will be higher the longer you wait to apply.

This article does not necessarily reflect the opinions of the editors or management of EconoTimes