What are the effects of rising interest rates?

Learn about the effects of interest rate rises on the economy, consumers and businesses, and how you can take advantage of the market volatility that often surrounds central bank decisions by trading the financial markets.

Bank of England
Source: Bloomberg

Every country’s central bank has the responsibility for determining its interest rates. In other words, the rate at which a borrower needs to repay a principal debt to a lender, such as a bank or credit provider. If interest rates are raised, the cost of borrowing money increases, while if it is reduced, the cost of borrowing money decreases. Adjustments to rates aren’t taken lightly by central banks and will be carefully considered before being implemented to maintain monetary stability.

Interest rates are important components of any functioning economy, affecting everything from credit card and mortgage repayments, to consumer spending and inflation. Interest rate announcements are closely followed by traders, as opportunities in the forex and stock markets often arise when these rates are adjusted. Here we pay particular attention to the effects of rising interest rates, and how you could take advantage of them by trading the financial markets.

How do higher interest rates affect the economy?

Higher interest rates affect the economy in a number of ways, from curbing consumer spending and stalling the growth of businesses, to determining the value of a country’s currency and the performance of financial markets.

A central bank will typically hike rates when inflation gets too high, making it more expensive for commercial banks to borrow money from it. Commercial banks, in turn, will shift this extra cost on to consumers and businesses, making borrowing money more expensive for them as well. This increased cost of credit can dampen consumer confidence, leading to a reduction in spending on goods and services. Although inflation can eventually be lowered in this way, some businesses can come under increased pressure as a result of a decline in turnover.

Interest rates can also affect the value of a country’s currency. Generally speaking, when a country’s official interest rate is raised, its currency will appreciate. This is because higher interest rates attract investment from foreign savers who live in countries where the rate of return is lower. This creates an increase in the demand for, and value of, that particular currency. Political and economic stability will, however, still have a greater bearing on a currency’s value than interest rates.

Stock markets may also react to adjustments in interest rates as investors factor in the effects of reduced borrowing and spending across the economy. For most companies, these factors will have a detrimental impact on future earnings, though there are some that will expect revenues and profits to rise in line with interest rates. These effects are explained in more detail in the ‘what effect does raising interest rates have on businesses?’ section.

How do rising interest rates impact consumers?

Rising interest rates impact consumers because the cost of borrowing money goes up. So if you have a mortgage, credit card or loan, you could end up paying more for the amount of money you originally borrowed. This will mean that consumers will end up having less money to spend on goods and services, which can slow down economic activity.

Rate hikes do, however, provide consumers with an incentive to save more money as they will receive a higher return on the cash that they hold with banks. In order to function effectively, a bank requires a steady stream of deposits to ensure that it can increase its lending capacity. Rather than borrowing money at a premium from central banks, it’s cheaper to simply raise capital from depositors by paying an attractive rate of interest on deposits — provided customers can be incentivised to save by a rate that’s below the one offered by the central bank.

Interest rates and inflation are also closely related. Since interest rates affect the cost of borrowing, and inflation affects the cost of saving, increasing one will result in a decrease in the other. Central banks have the difficult task of striking a good balance between the two by keeping interest rates low to encourage consumer spending, while also keeping inflation in check to ensure that the prices of goods and services remain affordable.

What effect does raising interest rates have on businesses?

Raising interest rates can have a big impact on many businesses because the demand for credit goes down, and consumers switch to saving money as opposed to spending it. Once fewer goods and services are being purchased, businesses start struggling to generate more revenue. When this happens, some businesses may be forced to change the way they operate, which could mean laying off workers or scaling back on production.

Higher interest rates may also discourage people from starting new businesses, as a loan to kick-start an enterprise may be too costly to service. Likewise, existing businesses looking to finance their expansion with a loan may end up deciding against it as the repayment terms would be unattractive.

Certain businesses can, however, flourish when interest rates are raised. Take financial services firms for example — the higher interest rates that they are now able to charge mean that they could make more profit. Discount retailers may also see an uptick in sales as consumers cut back on pricier items in favour of more affordable options.

Why are interest rate changes important to traders?

Changes in interest rates are important to traders because they can have a significant impact on financial markets, creating opportunities to trade.

The forex markets are often volatile in the period surrounding interest rate decisions, which could provide a number of opportunities to go long or short on a particular currency.

As mentioned earlier, when a country’s interest rate is raised it often makes its currency more attractive to investors. This is because its currency is likely to appreciate against those used in countries where interest rates are lower. The converse also holds true.

The prices of stocks can also fluctuate when interest rates are changed, as investors consider the potential effects on revenues and adjust their portfolios, so this could provide you with an opportunity to take a position on the rise and fall of public companies.

Many traders will try to predict what an interest rate decision will be and start taking positions on markets likely to be affected, usually just prior to the announcement or soon after. Interest rate announcements made by major central banks — the Federal Reserve (Fed), Bank of England (BoE), European Central Bank (ECB) and Bank of Japan (BoJ) — are particularly important in this regard.

You can speculate on financial markets when interest rates change with a CFD account. To ensure that you know exactly when central banks are going to change rates, keep an eye on our economic calendar.

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