How Interest Rate Affect Spending, Inflation and Yields

Now that the job market in the US is on the roll for 12 straight months, a raise in interest rate is expected in the next few months. Industry players and economics experts predict a June rate hike. Fed remains at close watch of economic indicators, but labor market developments are reasons enough to pull the trigger and raise borrowing costs.

Borrowing costs includes debt-related charges such as interest payments and financing fees that a borrower pays for taking debts. Regardless of credit score, debtors experience swelling borrowing costs as market interest rates increase due to prevailing economic expansion and increasing inflation.

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Interest Rate and Spending

When interest rates are increasing, borrowers are often reluctant to take up more debts considering the increasing charges they need to pay for loans. The higher the interest rate, the less willing the borrowers are to borrow money.

High interest rates discourage private individuals from getting salary loans, mortgages, car loans, student loans and even credit card debts. Meanwhile, business owners are discouraged from making huge equipment purchases backed by short-term loans.

Interest Rate and Inflation

Rising inflation or commodity prices often spark rising interest rates. This is the Fed’s way to control prices of goods and services. By raising interest rates, banks begin to charge more for borrowing money, which discourages spending. Demand for products and services, in turn, goes down, causing prices to go down and inflation is under controllable levels again.

Fed monitors both Consumer Price Indices (CPI) and Product Price Indices (PPI). When these indices goes up to more than 2-3% per year, Fed will increase federal funds rate, the rate that banks use when lending money to each other.

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Interest Rate and Stocks & Bonds

When interest rates increase, investor spending will decrease. This causes earnings or yields in stocks and bonds to fall. One way for businesses and the government to raise money is through sale of bonds and/or stocks, but as interest rates move up, prices go down.

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