What happens when interest rates rise..?

What happens when interest rates rise?

After years of near zero interest rates in so called developed economies, we are hearing about rate hikes.. hold on, why was it so in the first place? Why did they drop the interest rates? Yes – people should borrow and invest and business should boom to bring the economy back on its feet. Also, they want people to borrow and buy new stuff. Savings are not going to yield anything, so better spent. Buy stuff like TV and cars and mobiles and create demand in the market.  Get the economy back and running. So, demand, output and productivity (given that you’ll buy new machines at the lower interest costs) increases, and all is good.  Another aspect to keep in mind is the inflation. When rates are low and all is good, people gets strong purchasing power and they keep on buying with their higher income and prices rise. In a good economy, inflation means rising salaries, new jobs etc. Also, lower rates weaken the currency as demand for the same goes down. Ex: You don’t want dollar to invest in US, as the rates are lower in that country. This also results in buying abroad expensive, hence you end up buying domestic goods, further helping the economy.  

So the US, UK and other developed economies made people spend a lot to help the economy. So, now that perceiving economy is back on its feet, what now? Inverse of what is written above should happen. Borrowing costs rise, demand falls, profits fall, and equipment purchase is delayed. People should start losing their jobs. Normally, stocks should fall (due to lower profits and also suddenly other investments start looking good) and bond prices should go down (inverse relationship with interest rates). Currency should strengthen. People start saving rather than spending.  

However, we are in a different ball game here. We are increasing the rates not because we are at the peak of inflation. But we see signs of recovery in the economy. So in fact, people would find this is the perfect time to invest in equities. Also, there is normally a 12-month time lag from an interest rate change to above impacts. During that period, a higher rate would induce banks to market and lend more, resulting in more investments in the economy. Here, an improving economy and sudden push from banks may actually boost the economy rather than stall it. So if the economic indicators are strong enough, economy will withstand a rate hike and go on growing, resulting in stable growth, coupled with control over inflation. Especially, keeping interest rates low only serves one side of the equation – demand for funds. But will banks provide enough supply? Are they willing to lend? A bit higher rates should actually balance the equation – both demand and supply. If economy is showing signs that it can withstand a rate hike, the world should go ahead, and hope for the best.

To sum up, eventually when interest rates rise, what happens to an economy?

1.      The bulls go home. Equity market was the king for that last few years. Perception of lower profits, other investment options will put money out of the market.

2.      Borrowing costs go up. However, most companies have cleaned their books in the last few years. Recession was a good time to start afresh. In fact, most companies would be cash rich now and a hike in rates would be perceived as a stronger economy and open up other investment opportunities

3.      Fixed bonds will fall in value, due to obvious reasons. Yields will look less attractive in a rising interest rate environment.

4.      Real estate prices should start cooling, as mortgages become expensive. However, if a rate hike becomes a weapon for mass marketing by the bankers, a rather steep hike would be required to cool the markets.

5.      LIBOR pushes EBOR up which pushes lending rates up. Banks have so much surplus liquidity, and they will decide this is the right time to pitch in and win some good quality well prices assets.

6.      Funds may go back to developed world. As interest rates and economic perception remained low in the western world, funds have been floating around globally in search of better yielding assets. For a strong economy however, it will not be an immediate issue.  

Overall, I believe a rate hike should be good. There are good and bad things that could happen. The normal 12 month lag for the real impact to set in provides good time frame for the economy to withstand and grow.  

PS: All said and done, the plunge in oil prices has actually dampened the situation. Lower oil prices will take the prices down; softening any chances that inflation could cause a rate hike. Inflation is well within Fed’s target rate of 2%. So, why would they hike the rates? Rate hike now seems pushed to late 2015 or early 2016.