Interest rates are rising. Can the economy handle the shock?

September 19, 2013, 11:44 AM UTC

When I was growing up in the 1960s, my dad, a doctor, was worried about the increasing use of narcotics among young people. He decided to take preemptive action with his two grade-school daughters by showing us a film depicting a heroin addict in withdrawal. My sis and I sat wide-eyed and open-mouthed as we watched a young man, strapped to a gurney, tremble and convulse, scream, throw up, and foam at the mouth (really) as his body fiercely fought detoxification. The film had its desired effect. To this day I’m loath to consume any drug more mood altering than a Benadryl.

As we anticipate our eventual withdrawal from the Fed’s bond-buying spree, I just can’t put the image of that convulsing young man out of my head. I fear that the Fed’s quantitative easing has acted like a narcotic over the past several years, putting our economy into a dreamy, feel-good state of near-zero interest rates and lofty stock and bond prices, even as its corpus — the part that actually makes and sells stuff — has been ailing. So I’m glad that the Fed is reducing the dosage, because it’s time we find out if the body economic has truly healed or whether it has underlying diseases that still need to be treated.

Unfortunately, the withdrawal symptoms could be severe. Let’s start with emerging economies, which are already feeling the pain. Cheap money here has been chasing higher returns there. Now that interest rates are going up here (the yield on 10-year Treasuries hit 3% recently, nearly double their 1.6% yield in May), the money is coming back to the U.S., wreaking havoc on emerging economies’ currencies and balance of payments. Their economies are slowing — indeed, Morgan Stanley has named Brazil, India, Indonesia, South Africa, and Turkey the “Fragile Five.” Hopefully they won’t go over the cliff, but their struggles will put a drag on the U.S. and global economies.

In America the housing market may suffer. Higher rates will mean higher mortgage payments, probably reducing demand, particularly for expensive properties. Borrowers with adjustable-rate mortgages will see their rates rise. Credit card rates are likely to go up, as are rates on other forms of consumer and business credit. On the other hand, homeowners and businesses who were smart enough to borrow on a long-term, fixed-rate basis will be sitting pretty. And if banks earn a higher yield on their loans, they might actually be willing to do more lending. So it may be easier to get a loan, but you will be paying more for it.

Speaking of banks, how will they fare? They didn’t handle very well the Fed’s last attempt to raise interest rates at the onset of the subprime crisis. They are a bit safer now, but periods of market volatility always expose the boneheads. Banks will see fees on mortgage and corporate refinancings dry up. Those with big holdings of low-yielding bonds will suffer losses. Banks that sold derivatives against interest rates rising could lose money. Offsetting those losses will be increased trading profits on market volatility and higher interest rates on loans.

Bond and stock prices, which traditionally move in the opposite direction of interest rates, will go down. In my humble opinion, both financial assets are inflated. Those bubbles need to be pricked. But savers with new money to invest will be the big winners, particularly seniors who will enjoy higher rates on low-risk bonds and CDs.

Yes, there will be pain, but if we can survive withdrawal, the biggest winner will be our economy, where investment decisions will once again be driven by economic fundamentals, not the Fed’s next move. The Fed has pumped $3.4 trillion into the veins of the bond markets. We can’t understand the full consequences of its withdrawal. We’ve been on this drug for many years, and as with any addiction, the longer you have it, the harder it is to break. Though a cold-turkey approach may be best for drug addicts, the best move for the Fed may be to go slow.

Fortune contributor Sheila Bair is former chair of the FDIC and author of New York Times bestseller Bull by the Horns.

This story is from the October 07, 2013 issue of Fortune.