REGISTER
PRACTICE TRADING
LOGIN
A central bank’s mission is generally to keep the economy humming along – that means not too hot, not too cold, but just right. When the economy starts accelerating, and runs “hot”, inflation can get out of control. That’s when policymakers step in and raise interest rates, which is intended to cool down the economy and keep growth on track.
US interest rates are now on a sustained upward path as the US Federal Reserve, the world’s most important central bank, addresses soaring price pressures, whilst trying not to subdue economic growth. The Fed has many tools at its disposal, but its ability to adjust interest rates is its most prominent and valuable policy instrument.
After many years of near-zero interest rates, financial markets are waking up to relatively higher rates which are having a profound impact on different asset classes.
We discover why interest rates matter and what happens when they rise. We’ll consider the correlation of interest rates to inflation and the effect on monetary policy.
Key Points
- Central banks adjust interest rates to control economic growth and inflation, using them as a primary tool to maintain economic stability.
- Changes in interest rates directly affect the costs of borrowing and the returns on savings, influencing consumer and business financial decisions.
- The Federal Reserve and other central banks use interest rate adjustments as their main strategy to manage national economic conditions and promote stable growth.
What are interest rates?
In basic terms, an interest rate is the cost of borrowing money, or the reward for saving.
- If you are a borrower, an interest rate is the amount you are charged for borrowing money. The higher the percentage, the more you have to pay back.
- If you are a saver, the interest rate will tell you how much money you will receive, as a percentage of your savings. The higher the percentage, the more will be paid.
When people talk about ‘Federal Reserve interest rates’ and the ‘Fed rate’, they’re referring to the Federal Funds rate, or the Federal Funds target rate. This is the rate at which US commercial banks borrow and lend their excess reserves to each other overnight. These big institutions borrow overnight loans to satisfy liquidity requirements set by regulators, including the Fed.
- The Federal Open Market Committee (FOMC) is a branch of the Federal Reserve that determines the direction of monetary policy, which includes interest rates.
- The Committee has eight regularly scheduled meetings each year which set a target Federal Funds rate. It can adjust the money supply so that interest rates move toward the target rate.
- Policymakers make their decisions about rate adjustment based on key economic indicators that may show signs of inflation or other issues that can impact sustainable economic growth.
The Federal Funds rate, or simply the Fed interest rate, is the most important benchmark for bank interest rates in the US economy. This influences rates throughout the global economy.
Types of Interest Rates (Short-term vs. Long-term)
Interest rates can be divided into short-term and long-term categories, each serving different purposes in the economy. Short-term interest rates typically apply to loans and financial instruments that mature within a year, such as treasury bills or commercial paper. These rates are more sensitive to central bank policies and reflect immediate changes in monetary policy, making them a key tool for managing inflation and liquidity in the financial system.
On the other hand, long-term interest rates are applied to loans and investments that extend beyond a year, including mortgages and long-term bonds. These rates are influenced by expectations for future economic growth and inflation. While short-term rates are directly impacted by central banks, long-term rates are shaped more by market forces and investor confidence in the economy’s long-term prospects. Both types of rates play a critical role in shaping business and consumer behaviour.
To make it easier to understand the key differences between short-term and long-term interest rates, refer to the table below for a quick comparison.
| Short-term Interest Rates | Long-term Interest Rates | |
| Duration | Up to 1 year | More than 1 year |
| Influenced by | Central bank policies (e.g., Fed rate changes) | Market forces and economic expectations |
| Sensitivity | Highly sensitive to monetary policy changes | Less sensitive to immediate policy changes, more influenced by long-term inflation and growth expectations |
| Examples | Treasury bills, commercial paper, short-term loans | Mortgages, long-term bonds, corporate loans |
The Role of Central Banks in Setting Interest Rates
Central banks play a vital role in managing a country’s economy by controlling interest rates. As the primary authority for monetary policy, central banks, like the US Federal Reserve, use interest rates to either stimulate or cool down economic activity. By adjusting rates, they can influence borrowing costs, investment levels, and overall economic growth. This makes interest rates one of the most powerful tools for maintaining economic stability.
Policymakers within central banks meet regularly to evaluate the state of the economy and decide whether interest rates need to be raised, lowered, or held steady. These decisions are based on key indicators like inflation, unemployment, and economic output. By setting a target rate, central banks guide the broader financial system, affecting everything from personal loans to corporate investments and even global financial markets.
Why do Interest Rates matter?
The impact of interest rates extends far beyond central bank policy decisions, influencing nearly every aspect of the economy. Interest rates matter because they directly affect borrowing costs for individuals, businesses, and governments, shaping economic activity in profound ways.
If rates are higher, that will tend to restrain businesses, for example, from investing in buying new equipment or hiring more workers. Loans become more expensive while sitting on cash becomes more attractive. Companies borrow less and save more, putting a damper on economic activity.
Lower interest rates will encourage more people to borrow as banks ease lending requirements. This boosts retail and capital spending, helping the economy to grow.
A prolonged period of low interest rates, like we have seen in recent years, can see capital flow into risky assets to find a higher yield.
This is important for currencies and forex markets as bank interest rates will dictate the flow of capital into and out of a country. Investors, commercial banks and businesses will seek out countries with high interest rates and strong economic growth. This means there will be more demand for that currency, which causes that currency to strengthen. We have seen this happen with the US dollar in 2022.
Effects on Consumers and Businesses
Interest rates have a direct impact on both consumers and businesses by influencing the cost of borrowing and the return on savings.
Consumers
For consumers, higher interest rates mean that mortgages, car loans, and credit card debt become more expensive to manage. This can reduce disposable income and discourage spending on large purchases.
On the other hand, lower interest rates make borrowing cheaper, encouraging consumers to take out loans and spend more, which in turn stimulates the economy.
Businesses
For businesses, interest rates affect decisions related to investment and expansion. When rates are high, borrowing costs increase, making it less attractive for businesses to take out loans for growth or new projects. This can lead to reduced hiring and slower economic activity.
Conversely, lower interest rates reduce borrowing costs, enabling businesses to invest in new opportunities, hire more workers, and drive economic expansion.
Historical Trends in Interest Rates: What Can We Learn? [1]
Interest rates have shifted significantly over the years, responding to various economic conditions like inflation, unemployment, and crises. When inflation rises, central banks raise rates to cool the economy. Conversely, during downturns, such as the 2008 financial crisis or the COVID-19 pandemic, the Fed cuts rates to stimulate growth.
For instance, following the dot-com recession, the Fed raised rates in 2004-2006 to address a housing bubble. Later, during the housing market crash of 2007-2008 and the 2020 pandemic, the Fed cut rates aggressively to support the economy.
To better understand these trends, the table below outlines key periods of rate hikes and cuts:
| Year | Event | Fed Rate Change | Reason |
| 2005 – 2006 | The Housing Market Boom | Rate Hikes (+4%) | Cool down the housing market bubble |
| 2007 – 2008 | The Housing Market Crash | Rate Cuts (-2.75%) | Stimulate the economy during the crash |
| 2008 – 2015 | Great Recession Recovery | Rate Cuts (-2%) | Stimulate economic growth |
| 2019 | Trade War Concerns | Rate Cuts (-0.75%) | Prevent economic slowdown |
| 2020 | Coping with Covid-19 | Rate Cuts (-1.50%) | Stimulate growth during pandemic recession |
| 2022-2023 | Post-pandemic Inflation Surge | Rate Hikes (+5%) | Control rising inflation |
Why Do the Federal Reserve Raise Interest Rates?
The job of the Fed, and generally most central banks, is to try and fix interest rates in a way that will help set the backdrop for promoting the conditions of maximum sustainable employment and price stability.
Price stability means moderate inflation – that is the steady rise in the prices of goods and services which comes with stable economic growth.
So, central banks like the Fed raise interest rates to help bring inflation back down to moderate levels. It is a policymaker’s role to use their inflation forecast to keep the rate of inflation low. The FOMC seeks to achieve a rate of 2% over the longer run.
Recently in 2022, interest rates have been on the rise due to inflation hitting multi-decade highs for several different reasons [2].
- The cost of living has risen sharply over the last year since the pandemic crisis began.
- Global supply problems and rising energy prices have been a feature of the pandemic and Ukraine conflict.
- A tight labour market, that is one which demands for labour is at least as strong as supply, is also pushing up domestic inflation in the US.
Interest rates and inflation
Changing interest rates takes time to work and influence the economy. The Fed can’t do anything about the immediate impact of higher prices. But the use of higher interest rates can help bring inflation back down towards their 2% objective. Most economists believe it is likely that inflation will stay elevated for a prolonged period of time in 2022 before falling.
How high interest rates rise all depends on what happens in the economy. And how that may impact the rate of inflation over the next few years. The ‘terminal rate’ is a key issue for both investors and policymakers. This is the point where the Fed Funds rate will peak and is currently expected to be around 3% [3]. It is worth noting that US interest rates have averaged above 5% over the last fifty years.
The Fed is not expecting interest rates to reach the very high levels that some people experienced in the past. The FOMC will review how the economy is doing and has stated that they will raise interest rates at its next few meetings. Policymakers come together eight times a year, or roughly every six weeks.
How Inflation and Interest Rates Are Connected
Inflation and interest rates are closely tied. When inflation rises, central banks raise interest rates to make borrowing more expensive, which helps reduce consumer spending and cool down the economy.
Conversely, when inflation is low, central banks may lower rates to encourage borrowing and investment, which can stimulate economic growth. The goal is to maintain a balance where inflation is moderate, allowing for steady economic growth without overheating.
The Long-Term Impact of Inflation Control.
Controlling inflation through interest rate adjustments has long-term effects on the economy. Consistently high inflation can erode purchasing power and increase the cost of living, so central banks use higher rates to slow it down.
Over time, this promotes economic stability by fostering a healthy balance between price increases and sustainable growth. While rate hikes may initially slow down the economy, they help prevent damaging inflationary spirals in the long run, creating a more predictable environment for businesses and consumers alike.
Conclusion
As the Federal Reserve signals potential interest rate cuts, the economic landscape is poised for change. With inflation easing and the job market cooling, policymakers are shifting their focus toward maintaining sustainable growth. Interest rates have been held at a 23-year high of 5.25% to 5.50% since July 2023, but upcoming adjustments aim to balance inflation control with economic expansion.
These changes are intended to ensure both stability and opportunity in the long run. Understanding how these rates impact borrowing, saving, and investment decisions will remain crucial for consumers and businesses alike. “Discover how the 2024 Fed rate cut could affect your financial decisions in our article ‘What is the Potential Impact of the 2024 Fed Rate Cut?’. Stay informed to make the most of these shifts in the economy.”
References
- “Federal Funds Rate History 1990 to 2024 – Forbes Advisor” https://www.forbes.com/advisor/investing/fed-funds-rate-history/ Accessed 9 September 2024
- “UK inflation hits fresh multi-decade high of 6.2% on surging energy prices – CNBC” https://www.cnbc.com/2022/03/23/uk-inflation-hits-fresh-multi-decade-high-of-6point2percent-on-surging-energy-prices.html Accessed 30 May 2022
- “Traders Defy Fed Hawks as Half-Point Hike in July in Doubt – Bloomberg” https://www.bloomberg.com/news/articles/2022-05-25/traders-begin-to-doubt-a-third-half-point-fed-rate-hike-in-july Accessed 30 May 2022
