What Interest Rates Measure
The term interest rate could mean anything from the Fed Funds rate to any of the Treasury Note yields to the 30-year fixed-interest mortgage rate. Since these rates usually move together, the term interest rate usually means any bank lending rate.However, the rates don’t always move in tandem because they are driven by different forces. Variable-interest rate loans are driven by the Fed Funds rate. These rates are directly controlled by the Federal Reserve.
Rates on longer-term loans, such as the 15-year and 30-year fixed mortgages, are driven by 1-year, 5-year, and 10-year Treasury Note yields. These are auctioned on the open market, and the yields respond to market demand. If there is a great demand for these bonds, then the yields can be low. If there is not much demand, then the yields need to be high to attract investors.
These are the most important interest rates:
- Treasury Note: Like any loan, the interest rates are fixed. However, Treasury notes are auctioned to the highest bidder. Depending on the demand at auction, the note could cost more or less than face value. However, at the end of the note's term, the U.S. Government pays back full face value to the bidder. In effect, bidders are loaning the bid amount to the U.S. Government. In return, they get the interest rate and the full face value.
- Fed Funds Rate: The target interest rate set by the Federal Reserve. For more, see How Exactly Does the Fed "Cut" the Rate?
- LIBOR: This is the rate banks use to charge each other for overnight loans to meet the Fed's reserve requirements.
- Prime Rate: What banks charge their best customers. It varies with the Fed Funds rate.
- Variable Interest Mortgage Rate: This rate is usually a few points above the prime rate. Therefore, it varies with the Fed Funds rate.
- Fixed Interest Mortgage Rate: This rate is fixed for the loan's term, either 15 or 30 years, and is very close to the 10 or 30 year Treasury Note yield.
Why Interest Rates Are Important
Interest rates control the flow of money in the economy. High interest rates curb inflation, but also slow down the economy. Low interest rates stimulate the economy, but could lead to inflation. Therefore, you need to know not only whether rates are increasing or decreasing, but what other economic indicators are saying.- If interest rates are increasing and the Consumer Price Index (CPI) is decreasing, this means the economy is not overheating, which is good.
- But, if rates are increasing and GDP is decreasing, the economy is slowing too much, which could lead to recession.
- If rates are decreasing and GDP is increasing, the economy is speeding up, and that is good.
- But, if rates are decreasing and the CPI is increasing, the economy is headed towards inflation.
How Interest Rates Affect the U.S. Economy
Interest rates affect the economy slowly. When the Fed changes the Fed Funds rate, it can take 12-18 months for the effect of the change to percolate throughout the entire economy. As rates increase, banks slowly lend less, and businesses slowly put off expansion. Similarly, consumers slowly realize they aren't as wealthy as they once were, and put off purchases.However, the stock market watches the monthly FOMC meetings like a hawk. A .25 point decrease in the rate immediately sends the market higher in jubilation because it knows that will stimulate the economy. On the other hand, a .25 increase in the rate can send the market down, as it anticipates slow growth. Stock analysts pore over every word uttered by anyone in the Fed to try and get a clue as to what the Fed will do.
Recent Interest Rate Trends
The current Federal Reserve interest rate is between zero and .25%. It was lowered by 1/2 point on December 17, 2008, the 10th rate cut in a little over a year. The Fed began dramatically lowering rates on October 29, 2008 in response to the bank credit crisis. For more on the Fed's actions, see Current Federal Reserve Interest Rates.The recession was actually predicted by an inverted yield curve. This is when the Treasury Note long-term rates are lower than the short-term rates.
The Interest Rate Outlook
Federal Reserve Chairman Ben Bernanke has said that the most important role of the Fed is to maintain consumer and investor confidence in the Fed's ability to control inflation. This means the Fed is always more likely to raise rates to prevent inflation. However, the Fed won't raise the Fed Funds rate until Bernanke is sure the economy is safely out of the recession. The Fed has many tools in addition to the Fed Funds rate. These can also be used to prevent inflation. For more, see Fed Exit Plan Puts to Rest Inflation Fears.How Interest Rates Affect You
The most direct impact interest rates have is on your home mortgage. If interest rates are relatively high, your loan payments will be greater. If you are buying a home, this means you can afford a less expensive home. Even if you are not in the market, your home value will not rise and could even decline during times of high interest rates.On the other hand, high interest rates curb inflation. This means the price of other goods like food and gasoline will stay low, and your paycheck will go further. If you were smart enough to lock in a fixed-interest loan at a low rate, your income will stretch even more.
If interest rates stay too high for too long, it causes a recession, which create layoffs as businesses slow. If you are in a cyclical industry, or a vulnerable position, you could get laid off. (Updated January 3, 2010)
