Interest Rates in Society: The Federal Reserve’s Impact
Updated: Nov 28, 2022
In September 2022, the Federal Reserve, the central banking system of The United States, announced they were going to raise federal interest rates. Naturally, this is causing the American public to question what this will mean for the economy and their day-to-day lives.
What Are Interest Rates?
As of October 2022 - according to the Internal Revenue Service (IRS) - the annual interest rate is 3.40% AFR. This time last year, it was 0.18%. AFR stands for applicable interest rate and is used “to determine the original issue discount, unstated interest, gift tax, and income tax consequences of below-market loans''. For US citizens, AFRs essentially define the minimum interest rate the IRS allows on private loans. The rising interest rates are an important issue to the public because they cause consumers and businesses to cut back on spending, which could send the economy into a recession. In addition, businesses and consumers will begin to cut back on this spending because, as interest rates rise, so do borrowing costs and credit card bills.
How do Interest Rates Have an Effect on the Economy?
Many recessions have been caused by fluctuations in interest rates, most notably the 2008 recession, which contributed to the housing market's collapse. Bringing incredibly low interest rates, this recession made borrowing and paying back loans less expensive than it typically would. As a result, many families started borrowing money to buy houses despite having poor credit. Combined with low housing prices, when this “housing bubble” burst, people were left with houses worth less than their mortgages. This bursting caused the economy to spiral into a recession when the banks found out they were losing money.
Although decreasing interest rates caused the 2008 recession, increasing rates can have numerous problematic economic effects. According to a New York Times article published in June 2022, the Federal Reserve is raising interest rates in hopes of driving down the price of inflation. Inflation is the rising prices and the subsequent fall in the purchasing value of the standard dollar. This is often caused by the government printing more money.
Known as the economic cycle, as inflation increases, so do interest rates in an attempt to decrease prices for customers. One current example of high inflation is evident in the excessive prices of used cars. Because of high interest rates, mortgages, car loans, and general borrowing are more expensive.
The Federal Reserve hopes to stop consumers and businesses from spending so much. The general goal of increasing federal interest rates is to slow down inflation: an act that will benefit all consumers, even if the increase of both seems dangerous right now. However, this may have the opposite of its intended effect and could cause unemployment and the slowing of house sales, which could send the economy into a recession.
On a microscale, rising interest rates affect consumer spending. Credit cards are one of the main ways consumers buy items. Interest can compound if payments aren’t made by the month’s statement, meaning that current high interest rates can increase the amount of money owed to the bank after a late payment. This implies credit card bills will be, increasing since 2021.
High interest rates also tend to affect the stock market. Because companies are affected by AFR borrowing costs, they have to raise prices on their products or services. Inversely, since customers are also affected by high borrowing costs, they will be less likely to spend money on company products or services. This causes a cash flow drop which influences the price of a company’s stock. Therefore, if many companies see a decline in their stock prices, the entire stock market will be negatively affected.
How Do Different Political Ideologies View Them?
Interest rates fall under a policy known as monetary policy. Monetary policy “is a set of tools a nation's central bank uses to control the overall money supply and promote economic growth and employ strategies such as revising interest rates and changing bank reserve requirements.”
Conservative ideology views high interest rates favorably as fiscal action. This belief heavily favors economic stability and growth. Because of the rampantly high inflation, conservative belief sees the Federal Reserve raising interest rates as having a positive impact on the economy.
On the other side of the spectrum, liberal ideology views monetary policy unfavorably, including higher and lower interest rates. It sees even low interest rates as ineffective because it fails to stimulate the economy properly. Liberal belief would instead have the government focus its efforts on furthering spending in areas such as education, infrastructure, and unemployment benefits. This belief would also rather see money put into the hands of people to help create demand-boosting projects and products.
People should be informed about rising interest rates because they affect the economy of the nation they live in. The public needs to be aware of when to use their money to its highest value in the current economy, which high interest rates and inflation can affect. The Federal Reserve sets this rate and, even with good intentions, can cause the economy to spiral.