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An Economic Balancing Act in a Rising-Rate Environment

August 22, 2018

By Jim Darcy
Treasurer, ESL Federal Credit Union

The national economy is, by many measures, continuing to show strength: unemployment is near an 18-year low, consumer spending is robust, businesses are showing substantial investments and, as the U.S. Commerce Department reported recently, gross domestic product (GDP) surged to a seasonal and inflation-adjusted rate of 4.1 percent in the second quarter.

It begs the questions that with this many positive indicators in our economy, why does the Federal Reserve (the Fed) continue to raise interest rates? And when will these rates plateau or decrease?

Why does the Federal Reserve continue to raise interest rates? And when will these rates plateau or decrease?

Fed Chairman Jerome Powell said while announcing a hike in interest rates back in June 2018 that many of these metrics analyzed to determine rate adjustments continue to show favorable growth.

Because of these improved conditions, the Fed raised and signaled further increases in the federal funds rate in an effort to keep prices stable and inflation at around two percent, considered by many to be a sign of a healthy economy.

If inflation gets too high, it can eat away at the purchasing power of businesses and the value of retirement savings in bonds. If it is too low, worker wages can remain stagnant and business profits could decrease. This creates a delicate balancing act that the Fed must conduct in order to keep inflation and interest rates as stable as possible in today’s economic climate to promote sustained growth.

Rates are still historically low on common financial products such as credit cards, home equity and business lines of credit, auto and personal loans, and variable rate business term loans. They have been slowly increasing since 2015 and are expect to continue to increase since these products are affected when the federal fund rate changes. This means we are seeing increased borrowing costs for the consumer and businesses leading to increased loan payments.

Increased monthly payments for consumers and businesses? How is this good for the economy?

Lower rates make access to capital more affordable for consumers and businesses, however too much borrowing can overheat the economy and could cause inflation to skyrocket out of control. The Fed is gradually increasing rates in an effort to prevent the economy from running too rich and keeping the inflation rate at a reasonable level. The increase in the price of goods and services that simultaneously weakens the value of money in your wallet is essentially what the Fed wants to prevent from occurring too quickly.

Simply put: Lower rates fuel borrowing; higher rates prevent borrowing from getting out of control. Extremes on either end of the spectrum can be harmful, hence the delicate balance that the Fed is practicing today.

While higher rates can be seen as more costly to pockets and bottom lines, this can provide opportunity to those who are more risk averse, or conservative, in their financial management. These consumers tend to be more active in a climate such as what we see today because the products they often turn to are positively affected by the Federal rates—certificate of deposits (CDs) and other short-term investments, money market or savings accounts. As rates increase, these products tend to produce a higher rate of return on savings dollars.

With the Fed signaling further rate increases in 2018 and into 2019, the delicate balancing act between borrowing and inflation will not be going away anytime soon. The economy is continuing to show improvements in the economic indicators such as employment, spending and GDP, while inflation tracks around the 2.0% target. If these data points continue to progress, there will be little reason for the Fed to change the path of future rate increases.