5 Important Things to Know About Higher Interest Rates

Economic policy is shaped by fiscal policy and monetary policy. Broadly speaking, fiscal policy covers taxation and government expenditure, while monetary policy includes interest rate decisions, and asset …

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Economic policy is shaped by fiscal policy and monetary policy. Broadly speaking, fiscal policy covers taxation and government expenditure, while monetary policy includes interest rate decisions, and asset purchases. A central bank is the custodian of all monetary policy for a country. The Fed is the overseer of monetary policy in the US, the Bank of England in the UK, and the European Central Bank in Europe. These monetary authorities are responsible for formulating policy decisions that dramatically affect the global economy.

The Fed’s decisions vis-à-vis interest rates determine the relative strength or weakness of the USD. Quantitative tightening (higher interest rates) increase the value of the USD while quantitative easing (financial stimulus) routinely weakens the value of the USD. Much the same is true with the BOE and the GBP, the BOJ and the JPY, the BOC and the CAD, and the ECB and the EUR.

On Thursday, 2 November 2017, the Bank of England voted to hike interest rates for the first time since 2007. This decision was significant, given that the UK economy has been subject to an inflation rate of 3% (September figures) while real wage growth is lagging. The Bank of England’s Monetary Policy Committee (MPC) voted 7-2 in favour of a rate hike. The 25-basis point decision brings the UK bank rate up to 0.50% – markedly lower than the Fed’s federal funds rate of 1.00% – 1.25%.

A move towards higher rates

Nonetheless, central banks around the world are inching towards higher interest rates as global conditions gradually recover from the 2007/2008 financial crisis. In the UK, the thinking is that a gradual tightening of monetary policy will result in improved production, more affordable imports, and a gradual appreciation of real wages. The UK has been targeting an inflation rate of 2%, and it estimates that that figure will be reached within the next year or two. The Bank of England has downgraded GDP growth prospects from 1.7% to 1.6% for 2017.

The OECD (Organization for Economic Cooperation and Development) estimates that 2018 GDP growth in the UK will be just 1%. If this holds true, it will be the weakest to GDP growth of all the G-7 nations. Part of the problem with weak UK GDP growth is the uncertainty around the Brexit issue. Britain has been locked in tense negotiations with its EU partners. Brexit secretary David Davis and Prime Minister Theresa May have been hard at work trying to state Britain’s case to the EU negotiating team led by Michel Barnier. Britain is concerned about the rising uncertainty fueled by the divestiture (disinvestment) of foreign capital from the UK.

Central bank activity and everyday life

Central banks are entrusted with the task of stabilizing the economy in the face of such overwhelming volatility. Whether it’s the Fed, the Bank of England, the European Central Bank, or the Bank of Japan, monetary tightening can have far-reaching implications on everyday citizens. Olsson Capital trading expert Samuel Nell routinely talks of 5 important things to know about how rate hikes influence your life:

  1. Prices are impacted directly by increasing interest rates – when interest rates rise, things become relatively more expensive and big-ticket items such as cars, houses, and expensive vacations tend to see weaker demand.
  2. Employment prospects change – every time the federal funds rate or the bank rate increases, this has a dampening effect on economic growth and prosperity. Since money is harder to come by, businesses are less likely to part with it.
  3. Household credit is impacted – when the interest rate rises, you will pay more on borrowed money. This makes lines of credit more expensive, and this eats into your personal disposable income levels.
  4. Higher interest on CDs and interest-bearing savings accounts – this is one of the few positives of higher interest rates. People with savings in their accounts will benefit from higher interest on their investments.
  5. Mortgages and automobile loans become more expensive – this is arguably the most destructive component of higher interest rates since mortgages become significantly more expensive over their lifetime, but borrowers can still lock in fixed interest rates when there is a trend towards rising interest rates.

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