The Federal Reserve, often simply called "the Fed," is the central bank of the U.S. As a key player in shaping monetary policy, its most potent tool is the ability to influence interest rates. But why does the Fed choose to cut rates when economic troubles arise?

The Fed's straightforward monetary theory is that cutting rates decreases borrowing costs, prompting businesses to take out loans to hire more people and expand production. This, in turn, stimulates economic activity and growth. Conversely, when the economy is overheating, the Fed may raise rates to cool things down and prevent inflation from spiraling out of control.

When interest rates change, there a🍒re real-world effects on how consumers and businesses can access credit to make necessary purchases and plan their finances. These changes ripple through v🔯arious sectors of the economy, affecting everything from mortgage rates to stock prices and even some life insurance policies.

Here, we look at the impact on various parts of the economy when the Fed changes interest rates, from lending and borrowing to consumer spending to the stock market. This article explores how consumers pay more for the capital required to make purchases and why businesses face higher costs tied to expanding their operations and funding payrolls when the Fed changes rates. However, these entities are not the 🍷only ones that encounter higher costs, as this article explains.

Interest Rates and Borrowing

Lower interest rates directly impact the 澳洲幸运5官方开奖结果体彩网:bond market, as yields on everything from U.S. Treasurys to corporate bonds tend to fall, making them less attractiv🎃e to new investors. Bond prices move inversely to interest rates, so as interest rates fall, the price of bonds rises.

The effects on bonds depends on the type:

1. Government bonds: These are highly sensitive to interest rate changes. When rates fall, government bond prices typically rise the most, as they are considered the safest investments.
2. Corporate bonds: These are also affected, but the impact can vary based on the creditworthiness of the issuing company. High-quality (investment-grade) 澳洲幸运5官方开奖结果体彩网:corporate bonds tend to follow government bonds more closely than lower-quality (high-yield) bonds.
3. Municipal bonds: These are affected like corporate bonds but may also be influenced by local economic conditions and tax considerations.

In addition, an increase in interest rates sends the price of bonds lower, negatively impacting fixed-income investors. As rates rise, people are also less likely to borrow or refinance debt since it is more expensive.

The Prime Rate 

A Fed rate hike immediately fuels a jump in the 澳洲幸运5官方开奖结果体彩网:prime rate, which the Fed calls the Bank Prime Loan Rate. This is the rate that banks extend to their most credit-worthy customers.

This rate is the basis of other forms of consumer credit since a higher prime rate means that banks will increase fixed- and variable-rate borrowing costs when assessing risk on less creditworthy companies and co✨nsumers.

The prime rate typically changes quickly in response to Fed rate changes, often within hours or days. Most banks adjust their prime rate in unison following a Fed announcement. While the Fed doesn't directly set the prime rate, changes to the 澳洲幸运5官方开奖结果体彩网:federal funds rate are passed through almost immediately.

Historically, the prime rate has changed as frequently as the Fed adjusts its target rate, which can be several time🐼s a year during periods of economic volatility or remain steady for💯 months or even years during periods of stability.

For example, when the Federal Reserve 澳洲幸运5官方开🅠奖结果体彩网:cut the Fed funds rate by 50 basis points to a range of 4.75% to 5% on Sept. 18, 2024, it warranted major news coverage ac🎐ross the U.S. since it hadn't cut the rate at all in the previous four years. Thus, The Fed shifted its strategy during th🍌e post-pandemic period, combatting inflation and reiniting the markets as signs of flagging hiring.

Credit Card Rates

Working off the prime rate, banks determine how creditworthy other individuals are based on their risk profile. Rates are affected for credit cards and other loans because both require extensive risk-profiling of consumers seeking credit to make purchases. Short-term borrowing will have higher rates than those considered long-term.

澳洲幸运5官方开奖结果体彩网:Variable-rate credit cards are directly tied to the prime rate. When the Fed raises or lowers rates, the prime rate changes, and variable-rate credit cards typically adjust th🦄eir rates within one or two billing cycles. This means that cardholders can see their interest chargಌes increase or decrease relatively quickly.

Savings 

Money market and certificate of deposit (CD) rates 澳洲幸运5官方开奖结果体彩网:increase because of the uptick of t🎶he pr🍷ime rate. In theory, that should boost savings among consumers and businesses because they can generate a higher return on their🎶 savings.

Meanwhile, those with debts would shift their funds to pay them off since those are likely climbing higher than the rates they can get from such financial products.

Traditional savings vehicles like bank accoun🍰ts and CDs offer minimal returns in a low-interest-rate environment. This can push investors towౠard riskier assets in search of higher yields. For example, investors might turn to high-yield bonds, dividend-paying stocks, or real estate investments. While these can offer better returns, they also come with increased risk.

U.S. National Debt 

A hike in interest rates boosts the borrowing costs for the U.S. government, fueling an increase in the 澳洲幸运5官方开奖结果体彩网:national debt and increasing budget deficits. According to the Committee for a Responsible Federal Budget, the estimated total budget deficit from 2022 to 2031 will be $12.7 trillion. Increasing rates by just half a percentage point would increase the deficit by $1 trillion.

National debt as a percentage of GDP is expected to be 107.5% in 2031. If rates were 50 basis points higher, this would increase to 110.6% of GDP.

Business Profits

When interest rates rise, it's usually good news for banking sector profits since they can earn more money on the dollars that they loan out. But for the rest of the global business sector, a rate hike carves into 澳洲幸运5官方开奖结果体彩网:profitability.

That’s because the cost of capital required to expand goes higher. That could be terrible news for a market that is currently in an earnings 澳洲幸运5官方开奖结果体彩网:recession. ꧒Low🧜ering interest rates should be a boost to many businesses' profits as they can obtain capital with cheaper financing and make investments in their operations for a lower cost.

Auto Loan Rates

Auto companies benefited immensely from the Fed’s zero-interest-rate policy, but rising 澳洲幸运5官方开奖结果体彩网:benchmark rates will have an incremental impact. In theory, lower interest rates on auto loans should encourage car purchases, but these big-ticket items may not be as sensitive as more immediate needs borrowing on credit cards.

Mortgage Rates

A sign of a rate hike can send home borrowers rushing to close on a deal for a 澳洲幸运5官方开奖结果体彩网:fixed loan rate on a new home. But 澳洲幸运5官方开奖结果体彩网:mortgage rates traditionally fluctuate more in tandem with the yield of domestic 10-year 澳洲幸运5官方开奖结果体彩网:Treasury notes, which are largely affected by interest rates. Therefore, if interest rates go down, mortgage rates will also go down. Lower mortgage rates mean it becomes cheaper to buy a home.

Home Sales

Higher interest rates and higher inflation 澳洲幸运5官方开奖结果体彩网:typically cool demand 🔯in the housing sector. For example, on a 30-ye🐠ar loan at 4.65%, homebuyers can anticipate at least 60% in interest payments over the duration of their investment.

But if interest rates fall, the same home for the same purchase price will result in lower monthly payments and less total interest paid over the life of the mortgage. As mortgage rates fall, the 澳洲幸运5官方开奖结果体彩网:same home becomes more affordable—and so buyers should be more eager to🍷 make purchas🍌es.

Consumer Spending

A rise in borrowing costs traditionally weighs on consumer spending. Both higher credit card rates and higher savings rates due to better bank rates provide fuel for a downturn in consumer impulse purchasing. When interest rates go down, consumers can buy on credit at a lower cost. This can be anything from credit card purchases to appliances purchased on store credit to cars with loans.

Inflation

澳洲幸运5官方开奖结果体彩网:Inflation is when the general prices of goods and services rise in an economy, which may be caused bꦉy a nation's currency losing value or by 🍸an economy becoming over-heated—i.e. growing so fast that demand for goods is outpacing supply and driving up prices.

When inflation rises, interest rates are often increased as well, so that the 澳洲幸运5官方开奖结果体彩网:central bank can keep inflation in check (they tend to target 2% a year of inflation). If, however, interest rates fall, inflation can begin to accelerate as people buying on cheap credit can begin bidding up prices once again.

The Stock Market

Although 澳洲幸运5官方开奖结果体彩网:profitability on a broader scale can slip when interest rates rise, an uptick is typically good for companies that do the bulk of their business in the United States. That is because local products become more attractive du🥃e to the stronger U.S. dollar.

That 澳洲幸运5官方开奖结果体彩网:rising dollar has a negative effect on companies that do a significant amount of business on the international markets. As the U.S. dollar rises—bolstered by higher interest rates—against foreign currencies, companies abroad see their sales decline in real terms.

Companies like Microsoft, Hershey, Caterpillar, and Johnson&Johnson have all, at one point, warned about the impact of the rising dollar on their profitability. 𒅌Rate hikes tend to be particularly positive for the financial sector. Bank stocks tend to perform favorably in times of rising hikes. 

Although the relationship between 澳洲幸🀅运5官方开奖结果体彩网:interest rates and the stock market is fairly indirect, the two tend to move in opposite directions; as a general rule of thumb, when the Fed cuts interest rates, it causes the stock market to go up and when the Fed raises interest rates, it causes the stock market as a whole to go down. But there is no guarantee of how the market will react to any given interest rate change the Fed chooses to make.

The Bottom Line

When the economy falters, the central bank can step in to cut rates. The Federal Reserve is keen to react to rising inflation or a recession using this tool to lower the cost of borrowing so that firms and households can spend more and invest; with the goal of keeping the economy chugging along smoothly.