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Here's what Fed interest rate hikes mean

As the U.S. economy continues its slow but sure recovery, the Federal Reserve will, at some point, begin increasing interest rates. Many analysts believe that will happen sometime this summer, while others say it will be several months later or even not until the beginning of next year.

But it will happen at some point, and the key questions are: What are the consequences of rising interest rates? Should investors be worried? What about households?

Rising rates can affect the economy in several ways:

Business investment: When interest rates rise, it costs more to borrow money to finance investment projects, causing fewer investment projects to be profitable. For example, suppose a company has three investment projects in mind with expected revenues of 8 percent, 5 percent and 3 percent per dollar invested. If the interest rate is 4 percent, the first two projects should be profitable because the revenue exceeds the cost of borrowing. But the third one would lose 1 percent per dollar invested. And if interest rates rise to 6 percent, only the first project would be profitable and likely to be undertaken. Thus, as rates increase, the amount of investment falls.

Residential investment: The result is the same for investment in housing. When it's more costly to borrow money to purchase a home, the demand for new housing falls, and fewer homes are built. Residential investment has been a key factor in recoveries from past recessions, so if interest rates get raised too soon, it could make the recovery even slower.

Consumption of durable goods: Purchases of goods generally bought on credit, such as cars, motor homes, boats, etc., also fall when interest rates rise also because the cost of financing these goods goes up.

Interest on the government debt: A hike in interest rates will also increase the cost of financing government borrowings. According to one estimate, it "would easily add between $1 trillion to more than $2 trillion to America's debt over the next decade, compared to a scenario in which rates remain low." That would result in pressure to raise taxes or cut government programs, either of which would reduce economic activity (though the impact would depend upon the particular taxes raised and programs cut). And to the extent that it reduces infrastructure spending even further (after the nation failed to take advantage of low rates to boost that spending), higher rates could also be harmful to future economic growth.

Savers and lenders: When interest rates rise, those who rely on interest on savings or the revenue from lending money do better. At the same time, however, those who borrow money do worse (leading to the effects noted above). So, higher interest rates help savers and lenders, and hurt those who borrow money (or who borrowed in the past with variable-rate loans).

Asset prices: When interest rates go up, the price of financial assets falls. Thus, bondholders realize capital losses when interest rates are expected to increase because that will cause the prices of their holdings to fall. Similarly for housing prices: As interest rates go up, home prices go down. For the economy as a whole, this results in a negative "wealth effect" that can reduce household consumption.

Exchange rates: When interest rates go up due to tightening monetary policy, the value of the dollar relative to other currencies (of countries where interest rates are lower) tends to increase. That hurts American exporters and helps importers with the net result that the balance of trade worsens as exports fall and imports rise.

Finally, if raising interest rates has so many negative effects on consumption, investment, government spending and net exports, why undertake such a policy? The answer is that as the economy recovers and reaches full employment, low interest rates could lead to excess demand, an overheated economy and an outbreak of inflation.

Reducing aggregate demand though an increase in interest rates is intended to keep supply and demand in balance and avoid price increases that lead to inflation. If the timing of the interest rate increase is just right, the result is full employment without any increase in inflation.

But what if the Fed makes a mistake and raises rates too soon or too late?

If it moves too soon, it could slow the recovery or even cause it to stall, That would lead to higher unemployment for a longer period of time than if the Fed were more patient.

If the Fed moves rates too late, the risk is inflation. However, that would likely be short-lived because the Fed has effective inflation-fighting tools. Indeed, many analysts, myself included, believe if the Fed is going to make a mistake, the more costly error would be to raise rates too soon rather than too late.

But not everyone agrees with that assessment, so it remains to be seen how the battle between the inflation hawks, who want to raise rates sooner rather than later, and the doves, who counsel patience, gets resolved.

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