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What to expect if the Fed decides to increase interest rates
What's in store on the interest rate front? Consumers could benefit or get hurt from either action or inaction, and that explains why Fed officials, who meet this week, have grappled with the timing of an increase. - photo by Kevin Dobbs
Dan Wilde gave interest rates little thought when he started shopping for a new home this fall in Sioux Falls, South Dakota. Interest rates had hovered near historic lows for years, and he figured correctly that securing an affordable rate would prove simple enough.

But against the backdrop of an improving national economy and widespread speculation about a looming Federal Reserve interest rate hike, Wilde soon found himself in a crowd of home buyers who wondered how long the favorable consumer conditions would last.

"It definitely affects how quickly you have to make a decision," he said. "If you find a house you want, you have to act fast because someone else will be there soon enough to make an offer. People don't want to miss out on a house, end up waiting for something else and not finding it before rates do go up."

Wilde bought a home in October, but the experience left him wondering what's in store on the interest rate front and how it could affect him in coming years. And there is plenty to digest. Consumers could benefit or get hurt from either action or inaction, and that explains why Fed officials, who meet this week, have grappled with the timing of an increase.

Rate increase in 2015?

Following the financial crisis of 2008, Fed policymakers moved with haste to lower interest rates to encourage borrowing and stimulate economic activity that would ward off a depression. They brought down their benchmark rate as low as they could, and it has hovered between 0.0 percent and 0.25 percent since.

But with real estate markets on the mend and unemployment, at 5.1 percent, finally where Fed officials anticipate meaningful wage growth, policymakers have signaled in recent months that a rate increase is on the table for late 2015.

They have said rates will likely rise slowly, beginning with a quarter-of-a-percentage point bump. The Fed's monetary policy committee, tasked with guiding the economy toward full employment while maintaining moderate inflation, could act as soon as its next meeting on Tuesday and Wednesday.

While global economic sluggishness notably including a slowdown in China convinced officials to balk at raising rates in September, Fed Chairwoman Janet Yellen said at the time that an increase this year remained a realistic possibility. In a speech this month, Vice Chairman Stanley Fischer said the same. He emphasized that the global weakness, on its own, was not enough to derail U.S. economic progress and likely would not have "a significant effect on the path for policy."

Impact on consumers

A change in rates could impact consumers significantly in positive or negative ways.

The key short-term rate set by the Fed affects the interest that consumers pay on everything from credit cards to auto loans and other debt with short pay-off periods. Long-term rates, such as those that apply to 15- and 30-year home mortgages, historically have also been influenced by a Fed shift and, while not a given, often rise along with short rates.

The specter of higher rates worries many consumers. But leaving rates exceptionally low for too long could ultimately hurt the typical American, Fed observers say.

If left unchecked in a stronger economy, borrowing and spending could increase at unhealthy rates, leading to risky investments such as those that fed the housing bubble of the past decade.

Rapid upward price swings could also emerge if rates stay low as the economy heats up. The Fed views 2 percent as a healthy level for core inflation increases. If prices rise at twice that level or more, Americans could struggle to afford basic goods. And this could force the Fed to boost rates higher and faster to rein in inflation.

"More normal levels for interest rates help to ensure markets recognize bubbles before they burst," Mike Matousek, a U.S. Global Investors Inc. stocks trader and Fed observer, said in an interview. "And the Fed doesn't want to be late when it comes to inflation."

Matousek also noted that the Fed, citing an improving economy, has hinted at a rate increase for a couple years but ultimately has done nothing, infusing heavy doses of uncertainty about the economy among business executives. This has influenced many to scale back expansion plans, he said. The result is an economy, while growing, has not expanded as robustly as it could have, Matousek and other critics say.

"Taking that uncertainty out of the mix could actually help people plan and make decisions" that benefit the economy, Matousek said.

Borrowers vs. savers

On the other side of the interest rate coin, many aging Baby Boomers are moving into retirement and will grow increasingly dependent on the interest income they earn on savings. With rates unusually low, these savers are losing out on important income, said Lamont Black, a former Fed economist and current finance professor at DePaul University.

"The impact on savers is a key issue here," Black said in an interview. "In an important way, this is about borrowers versus savers."

What's more, some Fed observers say, many Americans who wanted to finance large new purchases have already done what they can on this front. With memories of the last recession still lingering, their collective appetite for more debt is limited, says Jack Ablin, chief investment officer at BMO Private Bank.

"Continually lower interest rates and diminishing debt capacity are weighing on consumers' ability and willingness to take on more leverage," Ablin said in a research report. This, he suggested, makes the Fed's low-rate policy ineffective and exposes the country to risk without any new reward.

Still too soon?

But others say if the Fed acts too soon on rates, it could cut off normal demand for loans and curb investment just as the fragile U.S. economy gains momentum.

The employment market, while uneven from month to month, has been relatively strong overall this year in terms of generating new jobs. The monthly average for job gains this year is 198,000, according to the U.S. Department of Labor. But wage growth has proven anemic. It has hovered around 2 percent, hardly enough to drive inflation. Indeed, the core inflation rate that the Fed focuses on has run at about half of the central bank's 2 percent target.

Noting that, Black said, the Fed has reason to be cautious. If it boosts rates before wages are clearly on the rise, inflation worries may quickly give way to the deflation of a shrinking economy.

So while a return to a more normal rate environment is the Fed's goal, Black says deciding when to flip the switch is understandably difficult. The last thing the Fed wants to do, he said, is to lift rates only to find it has stunted the economy and must cut rates anew.

Wilde, the home buyer in Sioux Falls, says he will wait patiently, content that he locked in a low mortgage rate when he did but curious what lies ahead. Of Fed policymakers, he said, "You just hope they get it right."
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