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The Possible Effects Of An Interest Rate Hike By The Federal Reserve

The Federal Reserve recently raised benchmark interest rate by 25 basis points from one per cent to 1.25 per cent.

06/29/2017 13:05 EDT | Updated 06/29/2017 13:05 EDT
Kevin Lamarque / Reuters
Flags fly over the Federal Reserve Headquarters on a windy day in Washington, U.S., May 26, 2017.

The Federal Reserve recently raised benchmark interest rate by 25 basis points from one per cent to 1.25 per cent. This will have effects on the U.S. economy as well as possible effects for Canada as well. The increase in the interest rate will affect both consumers and businesses. Also, the Federal Reserve plans to reduce its more than $4 trillion reserve of Treasury bonds and mortgage-backed securities that were mostly purchased during the Great Recession.

The increase in the interest rate will provide greater incentive to people to save more. As people can earn more from higher interest rates, they will save more money in banks. Therefore, the higher interest rate may lead to higher savings by U.S. citizens. However, it will lead to higher cost of borrowing, including for credit cards, which may affect consumer spending. Due to the higher cost of borrowing, including for credit cards, U.S. consumers may spend less on the purchase of goods and services. This may adversely affect U.S. consumer spending on Canadian goods and services as well.

As the U.S. is Canada's largest export destination, any potential shrinkage in U.S. consumers' expenditure on Canadian exports of goods and services will be deleterious for Canadian exporters. However, an improved U.S. economy may allow U.S. consumers to spend more on goods and services in spite of higher borrowing costs so that they may spend more on Canadian exports of goods and services as well.

The cost of borrowing to invest will increase as well. This may make businesses more reluctant to borrow to invest. However, overall business conditions have improved in the U.S. which has made a rise in interest rate feasible. Therefore, it is fair to state that businesses will borrow more to invest in spite of the increase in interest rates. It is possible that as credit becomes more expensive, businesses may decrease their purchase of equipments and services made in other countries, including Canada. This may hamper the sells of Canadians exporters to U.S. businesses. However, it is very likely that U.S. businesses will invest more in spite of higher borrowing costs due to improved business conditions, including purchases from Canadian exporters.

Also, the higher cost of borrowing may make goods and services manufactured in the U.S. more expensive if U.S. businesses decide to pass on the higher cost to consumers. This may make U.S. exports to Canada pricier so that Canadian consumers may end up spending more on U.S. exports of goods and services. However, a possible increase in prices of goods and services due to a 0.25 per cent increase in interest rates will be quite insignificant.

The higher cost of domestic borrowing may prompt U.S. businesses to seek lower borrowing rates outside the U.S., including Canada. The higher interest rates of borrowing may encourage U.S. businesses to borrow from Canadian financial markets and financial institutions. This may bring increased business for Canadian financial institutions. However, it may lead to increased competition for Canadian businesses to borrow in order to finance and expand their businesses. Even if these occur, the effects will be quite insignificant as the interest rate increases by only 0.25 per cent.

Again, foreign investments may flow into the U.S. due to better investment climate which means that the U.S. may experience higher foreign direct investment (FDI). Foreign capital funds may flow in to take advantage of higher returns offered by U.S. financial institutions due to the higher interest rate. However, with only a 0.25 per cent increase in interest rates, the effect on the flow of foreign capital funds will be very limited, if at all.

The increase in the interest rate may have some negative effects on U.S. consumer spending and business spending. This may possibly have a negative effect on Canadian exports of goods and services to its largest export destination. However, the effect will be quite insignificant and will be negated by increased U.S. consumer and business spending due to improved U.S. economic conditions, including expenditure on Canadian exports. Canadians may pay more for U.S. exports of goods and services if U.S. businesses decide to pass on the higher cost of borrowing to consumers. But, it will be quite insignificant as the cost of borrowing is increasing by only 0.25 per cent.

Also, the U.S. may experience increased foreign investments to take advantage of better investment climate and increased foreign capital inflow attracted by higher interest rates offered by U.S. financial institutions. But, the effect on foreign capital funds will be quite limited due to only a 0.25 per cent increase in interest rates. Finally, it may bring increased business for Canadian financial institutions as well as increased competition for borrowing funds by Canadian businesses, both of which may be muted as the Federal Reserve rate is increasing by only 0.25 per cent.

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