Interest Rates Federal Reserve Interest

Interest Rates

Federal Reserve Interest Rates and Economic Recovery

The recent global economic collapse brought many specific features of the financial world into sharp relief. The role that government policy plays in shaping financial security and long-term stability has been seen as of immense importance in the past few years, and this is quite understandable given the amount of wealth and productivity that was lost during the worst economic decline since the Great Depression. Everything from the various stimulus package components to whether or not certain politicians are focusing enough on "jobs creation" -- often a term more filled with political rhetoric than economic relevance -- has become a subject for intense debate and media (and presumably public) scrutiny. The problem is not simply that the public and its representatives can't agree on what needs to be done, but there is also disagreement about what certain actions would actually lead to.

Given the complexities of national and international finance and economic growth, it is perfectly understandable that there is a large amount of disagreement in these areas, yet decisions must be made. Issues like the interest rates charged by the Federal Reserve, which is the ultimate supply of money for the nation's banking system and thus the primary factor in the cost of capital for individuals and businesses alike, are of vital importance to future economic growth and stability. A low rate increases economic activity by making capital cheap, but at the same time this leads to inflation which could hurt the nation's long-term stability and the financial position of the dollar in the rest of the global economy. This paper will examine the effects of raising the interest rate on several key economic features and indicators.

Consumer Financing

When the Federal Reserve raises the interest it charges other banks for borrowing cash, these banks in turn charge the other institutions from them higher rates, and ultimately rates become higher for consumer (Magnuson 2008). This means that large-ticket items that consumers typically borrow funds in order to purchase -- real estate and new cars are the most common purchases financed in this way -- become more expensive in both the short- and long-term. A $200,000 loan for a home purchase with a standard 30-year fixed mortgage, for instance, has a monthly payment of $1,073.64, and around $185,000 in total interest; raising the interest rate just one percent means a monthly payment of $1,199.10 and total interest over the life of the loan of over $230,000 (MC 2011). The same house would cost more than a hundred dollars more each month and more than forty thousand dollars more over the life of the loan, meaning fewer consumers would purchase homes (or cars) until real prices (the actual cost of the real estate) dropped, which has a depressive effect on the economy (Magnuson 2008).

Annuity Values

Assuming that the terms of a given annuity are already fixed, a rise in interest rates could actually be a benefit by preserving the value of payments better than higher inflation would (CSS 2002). Higher inflation means that fixed payments have less purchasing power -- less real value -- over time, so continually depressed interest rates is dangerous to these payments (Magnuson 2008). This means that a higher interest rate would preserve purchasing power better.

NPV

This becomes more complicated when trying to determine the changes that would occur to the net present value of today's dollars, especially given the uncertainties involved with changes in the interest rate. On the one hand, the value of future dollars (i.e. today's dollars saved) is eroded by inflation, so a lower interest rate is detrimental to NPV; on the other hand, higher interest rates mean more lucrative lending and higher returns on many investment, which would mean a dollar invested today would be worth more in the future (Investopedia 2011). At the same time, higher interest rates could slow the pace of business and damage gains in the stock market, leading to diminished returns (Magnuson 2008). The effect of interest rates on the NPV, then, depends on other macroeconomic and financial effects.

WACC

The Weighted Average Cost of Capital would basically increase due to a change in interest rates, but more important are the effects that a change in interest rates would have on the various components of the weighted average cost of capital. As borrowing becomes more expensive, a lower debt to equity ratio would become more beneficial to many companies, and less borrowing (or slower growth) would be the necessary result (Investopedia 2011). This could boost investment opportunities for many individuals, but that would mean less money would be available for purchasing goods, which has a depressive effect on the economy…. Again, it is difficult to predict what will happen in such unstable times.

Corporate Earnings