Sent September 2022
I recently had a very smart but humble client ask me: “I’m sure it’s obvious, but I don’t understand why increasing interest rates is supposed to bring down inflation. Does it really temper the economy? Can you make that make sense?” That singular question is all the rage in the news right now, so I thought I’d use this month’s letter to dissect that big discussion.
When you were a kid, you might remember that ubiquitous playground toy, the teeter totter. With a weight on each side (ideally, your nice friend), you would enjoy the experience of one side going up while the other party went down. In the world of finance, interest rates and economies are not so dissimilar to the movement of that toy. However, let me also point out you don’t see teeter totters on playgrounds anymore because they hurt too many people when used inappropriately. Having now put that childhood memory in your brain and having the cautious warning in hand, let’s look at this phenomenon.
What Does It Mean to Say Interest Rates are Increasing?
First the setting: Jerome Powell is the head of the Central Bank in the USA (which I have written about before). When we say the United States of America Central Bank is raising interest rates, what we mean is that they are raising the Federal Funds rate, which truth be told is one of the only interest rates in the world that they control. But… that singular rate is a mighty important one because all banks in the United States must hold ‘federally-mandated reserves’ to back up their loans to assure the banking system is solid (liquid/safe).
Thus, technically what the Central Bank changes is the rate that FDIC-insured banks must pay to fellow banks who have excess reserves. This overnight borrowing is massive in size (hundreds of billions of dollars) but seamlessly organized, and these banks borrow and lend those reserves for one day all the time. Though negotiations on the rate are possible between two consenting adults (even banks should act like adults), it is such a bell-weather rate that these overnight loans bear interest at what is commonly called “the effective federal rate.”
How the Fed Funds Rate Affects Other Loans
Thus, the rate is like the canary in the coal mine, and once the FOMC (Federal Open Market Committee) increases the Fed Funds rate, what they also simultaneously impact is the interest rate at which banks make loans. That happens because if banks must hold reserves for every loaned dollar, the higher the overnight rate, the more expensive it is to hold those loans. Banks make up for that cost by passing it onto consumers in the form of higher mortgage rates for new loans, or they pass it onto companies through increases in their Line of Credit (LOC) borrowing rates.
How Interest Rates Impact Behavior
So far we have just talked about rates, but sooner or later rates turn into dollars and dollars turn into behavior influencers. Higher rates require more dollars to serve them, and the more you pay to a bank, the less money you have to pay for other things (like buying clothes or going out to eat).
Mortgage Loans & Consumer Behavior
A couple seeking a $300,000 mortgage at 3.25% would pay $1,305 per month. However, if that rate goes to 4.75%, the monthly payment goes to $1,564. That difference amounts to $93,579 more money being paid out over the life of the loan. That’s a lot of Hamburger Helper you buy instead of going out to eat and in an economy where consumers are 70% of the economy, the change is noticed.
Business Loans & Corporate Behavior
If a business has to pay more on their LOC loan, they are naturally less profitable. If companies are less profitable, they have less cash. In the private sector world, which is vastly different than the world of governments, facing less cash on hand those companies invest less in new projects or the hiring of people.
Ancillary Impacts
Beyond the above, we have the ancillary impacts of higher interest rates. When interest rates go up, less people can afford to build homes. We saw the number of new home permits decline by 9.6% in July[i]. Less building naturally means less hiring of cabinet makers, roofers, electricians, and plumbers. Less work translates into less income for workers, and then we migrate into the “multiplier effect” to consumer spending. You don’t need to be a highly paid economist to know which way that teeter totter is headed.
The Bottom Line
All said and done, we can’t have runaway inflation. Increasing interest rates is a blunt tool to combat inflation, but it’s one of the few the Federal Reserve has to dampen demand for goods and services in the economy. Just like when you were teeter tottering… you wanted the other person to let you down easy… to have a “soft landing.” Nonetheless, we have all experienced the harder bounces as well and now you know why the Central Bank is schizophrenic about how much is too much, and how little is too little. May we find the seesaw balance of just right.
It remains my deep and distinct honor to serve you well.
Patrick Zumbusch
Founder and CEO
Wellspring Financial Partners
[i] “Housing Market Faces Growing Risk Of Multi-Year Collapse As New Home Construction Craters” (Jonathan Panciano, Forbes.com, August 16, 2022)
