What Would Increased Interest Rates Do to the Economy?

Question: If the Federal Reserve raises interest rates by the end of 2010, what effect would this have on the overall economy? Let’s assume the economy is “recovering” at the rate Ben Bernanke states it is, as of today. People with a 401(k) and other retirement accounts could benefit. Would this be to the detriment of others (e.g., future homebuyers)? If so, would this be a bad thing? In some cases, workers invested and saved only to see their investments dwindle, while others bought homes and other big-ticket items they couldn’t afford. Thank you.

Paul Solman: Since there’s a queue of questions to answer I often can’t get to one like yours for awhile. In the interim, things can change. So while this question was timely in June when you sent it, I’m sure you’d now rephrase it. Still, the issue remains: What might be the effects of raised interest rates on 401(k) investors and future homebuyers? And your larger question: good or bad?

For investors, it all depends of course on what they invested in. Higher interest rates are bad for bonds. The simple reason is that if you’ve got a U.S. bond for $1,000 paying today’s 2.7 percent or so for the next ten years and interest rates shoot up, so will the yield on the NEXT 10-year $1,000 bond the Treasury issues. Otherwise, no one would BUY the new bond.

Okay, now there are two 10-year bonds that can be bought and sold in the open market. The interest rate on the old one is 2.7 percent; the rate on the newer one, higher. If the new one sells for $1,000, the old one is obviously worth LESS than that.

So, when interest rates go UP, the value of current bonds goes DOWN, as is happening today, Thursday, as I write this. Positive economic news suggests the economy might pick up, which might in turn induce the Fed to raise interest rates. In anticipation, bond investors start selling their current bonds, driving down the price.

But not all bondholders are hurt by higher interest rates. For example, not those of you who have heeded the advice of Boston University pension guru Zvi Bodie (“Bodie-sattva”), often repeated on this page. His advice: buy TIPS – Treasury INFLATION–PROTECTED Securities. U.S. government bonds, that is, which pay an interest rate linked to the inflation rate, and thus adjust automatically for changes in interest rates.

I could go on and on about the different classes of assets that 401(k) investors might hold, and how a rise in interest rates might affect them. But the bottom line is simply that it depends HOW they invested.

As for homebuyers, higher interest rates mean a mortgage will cost more. That would seem to be an obvious disincentive to buy. But not necessarily.

What a borrower should care about is the REAL cost of the loan: the price minus the inflation rate. You lend me money at two percent and interest rates zoom to five percent? Great for me. I pay you two percent, take the money I’ve saved and invest it at six percent, and pocket the difference.

The same would be true if I take out a mortgage at ten percent and interest rates climb even higher.

These examples are simply to make the point that “nominal” interest rates – the raw NUMBERS – are misleading. It’s REAL rates that matter.

By now, most of you have stopped reading. Those happy few left will now get my answer to the original question, “Is this a good or bad thing?” The implication of the question: that higher interest rates will justly reward well-behaved savers (Aesop’s ants) and the expense of the profligate grasshoppers of the boom.

Unfortunately, the answer is impossible to give. Suppose interest rates rise and, in so doing, discourage home buying. Housing prices drop further, leading to more foreclosures, leading to more toxic assets on bank balance sheets, leading to bankrupt banks. Then the virtuous 401(k) saver who happened to INVEST in those banks – buying their stock or just lending them money via bank bonds – will be punished.

So will the virtuous saver who thought s/he was investing in the safest asset of all: U.S. Treasuries. As explained above, they too will drop in value if interest rates rise, unless they’re TIPS.

In short (if you’ll pardon the expression at this late date), many things in economics are not quite so obvious as they seem. As the noted trade economist Robert Lawrence of Harvard’s Kennedy School once explained, the economy is like an elaborate machine, in which innumerable parts are intricately interconnected. No wonder predictions about the machine’s workings are so often wrong.