The threat of the Fed increasing interest rates has been going on for some time. An increase in the interest rate, also known as the federal funds rate, has one primary effect. Banks have to pay more to borrow money from the Fed. That’s it. However, this effect leads to several other effects.

When banks pay more to borrow money, everyone has to pay more to borrow money. This includes businesses. It also becomes more expensive for consumers to use credit, such as credit cards. Overall, business growth can slow and consumers are less interested in purchasing goods and services.

An increase in interest rates has several effects on investments:

1. It becomes more expensive to borrow money.

• Businesses that operate on credit will find their costs increasing. As interest rates increase, businesses aren’t able to borrow as much. This makes expansion more expensive and business growth tends to slow.
  • This is one of the primary reasons why higher interest rates hurt stock prices. The long-term growth opportunities are more limited.
  • When money is easier to borrow, businesses have the resources to expand more rapidly, and investor sentiment increases.

2. Many services and products increase in price to accommodate the higher costs

• When products and services become more expensive, fewer people purchase them. Price elasticity varies with the product and service, but sales can slow. This also hurts most businesses. Interestingly, commodity prices are considered immune to this phenomenon.

3. Bond prices tend to drop, causing an increase in yields.

• This is one of the reasons diversification between stocks and bonds is recommended. When economic conditions favor bonds, stocks tend to fall, and vice-versa. Being invested in both can be an effective means of hedging your risk.
• If you already own bonds and need to sell, you’ll likely receive a lower price for them.

4. Investors can leave stocks and flock to bonds.

• When interest rates rise, many investors will liquidate part of their stock holdings and move to bonds. Large sell-offs can further degrade stock prices.

5. Savings accounts become more attractive

• Arguably, the rate of savings can also increase during periods of higher interest rates. Investors can be less likely to spend money due to increasing prices. Savings accounts are also more favored because the returns are higher during periods of high-interest rates.

6. Rising interest rates also help to tame inflation.

• When the money supply is too great, prices tend to rise. Higher interest rates can help to control prices. This is counter to point number two.

This is a simplistic version of the effect of interest rates on investments. Some of the effects of high-interest rates are in opposition to each other. Predicting the exact impact of interest rates on a particular investment is complicated.

The interaction of the involved factors is what makes the economic theory so complex. Controlling the economy is a real challenge.

Low-interest rates stimulate growth in the economy. One way the government slows economic growth is to increase interest rates. Rising interest rates affect the behavior of businesses and consumers. Stock ownership becomes less attractive and bond ownership becomes more attractive.

Keep in mind that Warren Buffett doesn’t change his portfolio based on interest rates. Given his record of success, perhaps the average investor should consider a similar strategy. In the long run, interest rates will have a minimal effect on returns. Remember that interest rates are only one factor that influences stock prices.

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