Interest rates play an important role in the world of economics and finance. However, many people do not really understand how interest rates truly function in the business world.
The complexity of the subject sometimes results in mixed or inexact messages being transmitted to the public. On the other hand, most people get bored because it takes them too much time to understand the subject.
In reality, you do not have to become skilled at all the details of how interest rates work, be a specialist in financial policy, or know the dynamics of global currency fluctuations. As an alternative, just concentrate on what is truly important for your business.
Below are the basic things you should know about interest rates:
Higher Rates Don’t Have to Mean Less Consumer Spending
When the Fed increases interest rates, it is usually done to fight inflation. Inflation is normally the result of higher consumer spending. However, it is not only because rates are going up that consumers are just going to quit spending.
Do not forget that consumers are inclined to spend more because they are making more, or because they have more confidence in the economy. A hike in rates is an endeavor to boost more savings (and hence slow inflation). Nevertheless, while the economy gets better, consumers will tend to both more spending and savings. Therefore, it is very normal to see rates and spending go up at the same time.
Higher Rates are Both Good and Bad for Debt
It is widely known that higher rates are bad for businesses because it makes borrowing money more expensive. For instance, a bank loan with a 3% interest rate is far better than a bank loan with 6% interest, all else being equal.
Nevertheless, many do not realize that higher rates also make debt a better investment. This is because the higher interest rates go, the greater returns fixed income (debt) investing will provide. For instance, if a company is looking for somewhere to put their excess cash, a higher rate environment is usually a more advantageous state to be in.
Higher (or lower) Rates Aren’t Always Going to Correlate with a Higher (or lower) Dollar
People will often say that low interest rates will debase the US dollar or higher rates will make the dollar expensive. Theoretically, higher/lower rates should lead to a higher/lower currency value, assuming you only have one currency.
In reality, we live in a world of several currencies. Moreover, what really matters is how currencies are valued relatively to each other. Per se, interest rates are only part of the picture.
An example could be the US interest rates. At historical lows, people would expect the US dollar to be cheap relative to other currencies. However, the US economy is by far the strongest economy in the world. Consequently, many investors are buying dollar-dominated securities, and avoiding investments in weaker economic regions such as Europe and China. As a result, the US dollar has been one of the strongest currencies for the past year.
Indeed, interest rates can be complex. You only need to concentrate on what is most important to your business and let the economists worry about everything else.