Understanding The Implications Of An Interest Rate Hike

By: Annamaria Lusardi
Annamaria Lusardi (@A_Lusardi) is the Denit Trust Chair of Economics and Accountancy at the George Washington University School of Business, where she focuses on financial literacy and personal finance. She is also the founder and academic director of the Global Financial Literacy Excellence Center.

Pundits keep a close watch on the U.S. Federal Reserve as it meets to raise interest rates after seven years of effectively zero rates. Yet the reality is that many Americans know little about interest rates, and much less about the implications of a rate hike for their finances! This was one key finding from the recently released S&P Global FinLit Survey, gathered with the support of McGraw Hill Financial.

Photo by Markus Spiske on Unsplash

The goal of the international study was to compare adult financial literacy levels across more than 140 nations. Financial literacy was measured using questions assessing basic knowledge of four fundamental concepts: numeracy or capacity to do simple calculations in the context of interest rates, interest compounding, inflation, and risk diversification. Respondents were deemed “financially literate” if they could correctly answer three of the four questions (try the quiz yourself, here!). The Global Financial Literacy Excellence Center helped design the survey and analyze the results.

Staggeringly, we found that only one in three adults is financially literate around the worldWhile Americans fare a bit better, only a little more than half of US adults score this well, a finding that bodes ill for one of the world’s most advanced financial markets.

More importantly, our research has also identified what people don’t know about their finances. One giant void has to do with compound interest, despite the fact that many are quite vulnerable to interest rate changes. For example, only 66% of Americans who hold credit cards understand interest compounding. In Brazil, Latin America’s largest economy, only about half of credit-card holders can accurately answer our interest-compounding question. Similar results apply to borrowers elsewhere. The logical implication is that, whatever the Federal Reserve decides, most people will snooze through the news. This, of course, can be dangerous to debtors everywhere.

There are a few financial concepts that people do tend to understand, particularly inflation. Naturally, this topic is one where experience matters: having struggled mightily with hyperinflation in the late 1980s and early 1990s, two-thirds of Argentinians can answer an inflation question accurately. Similar patterns are observed in Georgia, Bosnia and Herzegovina, and Peru, all of which also suffered under hyperinflation in the past. By contrast, only half of Japanese adults understand the corrosive power of inflation, having suffered deflation over the past few decades. In the U.S., the figure is just shy of two thirds (63%).

Monetary policy affects households and household finances, yet what people know about some of its levers is limited. As interest rates start rising, some people will learn about interest compounding. But this begs the question: should experience alone be our teacher?


This piece was originally posted on December 16, 2015, on the Pension Research Council’s curated Forbes blog. To view the original posting, click here.
Views of our Guest Bloggers are theirs alone, and not of the Pension Research Council, the Wharton School, or the University of Pennsylvania.