Here it is March 2015 and we are looking at a possible rate increase in interest rates by the Federal Reserve Bank. That increase would not directly affect consumers, if it happens. The Fed monitors and sets the rates for several behind-the-scenes transactions between banks. The Prime Interest Rate most people hear about is usually tied to the Federal Funds Rate, which is what the Federal Reserve sets.
The Federal Discount Rate is the rate that the Federal Reserve charges member banks for loans from the Federal Reserve Banking system. These loans help to keep the banking industry afloat so that banks can lend money to businesses and consumers. The Prime Rate is usually the best rate offered to the very best customers of the banks.
Stock investors are reportedly not yet ready for these interest rates to start going up. Why is that? The economy is adding jobs faster than it has been for years. Some of the long-term unemployed people are starting to come back into the job market. And large retailers like Walmart are raising the minimum pay for their lowest-paid workers. All the pieces are almost in position for a resurgence of inflation and high interest rates help to control inflation.
But what may have investors spooked in today’s market is the fragility of the average consumer’s finances. Many families who lost their homes in the 2008-9 Great Recession no longer have the assets they once possessed to cover emergency loans. Worse, their credit scores have dropped and they don’t have access to a lot of credit any more.
These changes in consumer financing opportunities have forced businesses to tighten their belts in many ways, not just by cutting inventories (leading to manufacturing layoffs) but also by cutting costs (including spending less on advertising) and keeping prices low. In some industries the prices of products have crashed compared to where they were just a few years ago, although those price decreases are due in part to advances in technology and manufacturing processes.
The less a company charges for its products the less room it has for markup, and it walks a tighter line between profitability and failure. These narrower lines mean that employees may not earn as much money as they once did, bonuses may be smaller than in the old days, and fewer people are bringing home paychecks. It’s not yet clear that the American manufacturing sector is anywhere near as strong as it was 8 years ago.
With interest rates so low you would think that banks would make it easier to lend money to consumers for cars, homes, furniture, and other large, long-term purchases. But credit worthiness overall has declined and the banks have tightened their requirements for borrowing money. Hence, less money is being loaned to consumers now than in past years. Although this is considered good for the health of the banking industry (because no one wants to see their local bank fail) it is not a good situation for kickstarting the consumer-driven economy.
Therefore investors probably should not be as shaky about interest rates as they are. All indications are that raising the interest rates a couple of points over the next two years will not hurt consumers because the banks have already integrated their concerns about consumer credit worthiness into current vetting practices. Small business owners may also already have felt the punch and so may not be directly affected by interest rate increases for a while.
If that is the case then investors who are concerned about consumer spending probably have a clear road ahead for the next 6-8 months, assuming the Federal Reserve starts moving interest rates up by quarter points. An increase of no more than 1% in the Federal Discount Rate by the end of the year is probably not going to hurt the economy and may help keep future inflation in check. It will also restore some flexibility to the Fed’s muscle in case a real economic shock develops without warning.