On Wednesday, May 4, 2022 The Federal Reserve made a decision to raise interest rates. Let’s discuss what that means to you and the everyday person. I am going to make this as basic and simple as possible.
The economy grows by businesses and consumers completing financial transactions. These transactions include buying goods and services as well buying assets such as real estate. As more buying occurs, more demand occurs which makes the economy grow. A large amount of this buying occurs by using debt. When there is more cash and debt available it makes it easier to buy goods and services. We buy cars with loans or by leasing which is also debt. We buy houses with mortgages which is debt. When we have more cash and more available credit we can buy more. Now that we have some basics let’s move on.
Next, we will start with recent history. In 2020 the COVID-19 Pandemic caused global shutdowns in society that triggered an economic shutdown. When businesses and consumers stop spending the economy slows down. There is less money being spent also causing the need for less employees. This turns into layoffs and higher unemployment rates. The Federal Reserve steps in to help. The Federal Reserve’s (The Fed’s) job is to help manage a stable economic and financial system. The Fed is the Central Bank of the US.
As we know banks extend credit by providing credit cards, mortgages, auto loans and other lending products. These lending products help us, and businesses spend more. The Fed controls lending interest rates which in turn controls buying power. When the economy is running hot and there is a large amount of inflation the Fed will increase interest rates to slow down spending and slow down inflation. When interest rates are lower you can buy more, and business can buy more. For example, at a 1% interest rate for 60 months on a $50,000 car loan the payment is $854.69. If the interest rate is 6% then the payment will be $966.64. That is an increase of $111.95 per month. You would have $111.95 less per month to spend so it would reduce your ability to spend more. This would impact everyone to spend less to reduce inflation. As the interest rate goes up on your credit card, your payments go up as well causing you to have less disposable income to spend. When everyone has less to spend it slows down the economy and slows down spending.
We have seen prices of almost everything go up over the last 18 months. Gas, food, home furnishings and other products have higher costs today compared to 3 years ago. As of this writing, the March 2022 inflation rate was 8.5%. After the pandemic shutdown, the Fed cut rates to all time lows to encourage businesses and consumers to spend more. Congress agreed to send checks directly to people to have cash for spending. The combination of low interest rates and stimulus checks to stimulate the economy created a lot of money circulating in the economy. The combination of stimulus checks, low interest rates and short supply of everything creates price inflation. There are more buyers with cash and a low-cost of debt, it causes higher demand, resulting prices going up on goods and services. This is where we are now. To slow all of this down the Fed will increase interest rates to cool down spending to lower inflation. Expect higher rates on credit cards, personal loans, student loans, equity loans and so on.
That is a very simple summary. I hope this helps give you a basic understanding of interest rates, the economy and inflation. Use this information to avoid being Broke and Clueless. On another post I will go into mortgage interest rates forecast.