The Federal Reserve's interest rate decisions and economic recovery effects

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).

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

The effect of a higher interest rate on corporate earnings is something that is simpler to determine and easier to predict. As was stated above, a higher cost of borrowing is likely to lead to a lower debt to equity ratio, meaning that corporations will finance their operations more with equity -- selling shares of the corporation -- than with debt -- borrowing from banks (Investopedia 2011). This has two effects on corporate earnings. First, it means that the company has lower liabilities and that less of its earnings have to go to interest payments, meaning that the overall earnings of the corporation are going to increase, all else being equal. Increased equity financing, however, means that there are more owners of the corporation that are entitled to a share of the profits, so the corporate earnings become more diluted and, from an individual owner or potential investor's perspective, become less valuable. This could have a negative effect on business as a whole, as corporation might decide simply to forgo growth given the options of more expensive operating through debt financing or diluted earnings through equity financing.

Conclusion

At some point, interest rates will have to increase to stave off rampant inflation. It might be wise to wait until the economy is stronger, however, so that companies and individuals feel safer with more expensive debt loads. Only time will tell which action is implemented -- and which should have been.