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.
- 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:This is the rate that banks charge each other for overnight loans of reserve balances.
- Variable Interest Mortgage Rate: This rate is usually a few points above the prime rate, which is set by the Fed Funds 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 is bad.
- 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.Recent Interest Rate Trends
In early 2001, the Fed began lowering interest rates to avoid a recession. By mid 2004, it reversed direction and began raising rates to avoid inflation.Even though the Fed was raising short-term rates, long-term Treasury Note rates stayed constant. This was because foreign governments, such as Japan, China and oil-producing countries, kept buying bonds, despite their low rates, to stabilize their own economies.
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 will be more likely to raise rates if it suspects inflation, even if that risks recession.It is unlikely that the Fed will lower rates again, since the last cut was so dramatic. The Fed will continue to monitor both economic growth and inflation, and use each month's data to drive their decision.
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 could cause a recession, which could cause layoffs as businesses slow. If you are in a cyclical industry, or a vulnerable position, you could get laid off.
