Inflation, Interest Rates and the Fed

By: , dated January 25th, 2013

Interest rates measure the price of borrowing money. If a business wants to borrow $1 million from a bank, the bank will charge a specific interest rate that will usually be expressed in terms of a percentage over a given period of time. For example, if the bank loaned the money to the company at a 5% annual rate, the company would need to repay $1,050,000 at the end of the year. From the company’s perspective, the value of that $1,000,000 right now is greater than the $1,050,000 in a year (presumably because they have plans for the money), which is why they want to borrow it. For the bank, it is earning a 5% return on a one-year investment. Generally, there are two types of interest rates: floating and fixed. A floating rate, also called an adjustable rate, moves in step with a rate that is set outside of the lending institution, such as the prime rate (the rate at which banks lend to their best customers). For example, you might see a rate set at “prime plus 2%”. This means that the rate on the loan will always be 2% higher than the prime rate, which changes regularly. The prime rate changes to take into account the changes in inflation. The “real” interest rate is the nominal (stated) rate minus the rate of inflation. For example, if a bank were to give you a loan at the nominal rate of 9% and inflation was measured at 3%, the real interest rate that the bank earns would be 6%. Banks change nominal interest rates to stabilize the real interest rates they receive. A fixed rate is an interest rate that does not change for the life of the loan. For an individual taking out a loan when rates are low, the fixed rate loan would allow him or her to “lock in” the low rates and not be concerned with fluctuations. On the other hand, if interest rates were historically high at the time of the loan, he or she would benefit from a floating rate loan, because as the prime rate fell to historically normal levels, the rate on the loan would decrease.

Interest Rates and the Fed

Interest rates change on a regular basis. The rates that you pay on a mortgage or other type of loan will vary from day-to-day and week-to-week based on many macroeconomic variables, including inflation, unemployment rates, growth rates, tax laws, and the Fed’s policies and outlook. The Fed affects interest rates by setting two key rates, the discount rate and the federal funds rate. The discount rate is the rate which the Federal Reserve Bank charges its member banks for overnight loans. The Fed actually controls this rate directly, but it tends to have little impact on the activities of banks because these funds are also available elsewhere. The federal funds rate is the interest rate at which banks loan excess reserves to each other. While the Fed can’t directly affect this rate, it effectively controls it in the way it buys and sells Treasuries to banks. This is the rate that reaches individual investors, though the changes usually aren’t felt for a period of time .

So, why should the average investor care about interest rates? Of course, interest rates affect things such as loans and mortgages, but they also have an effect on the markets as well. As rates change, the demand for different types of investments will change as well. During periods of low interest rates, stocks are considered more attractive than bonds and other fixed interest investments-the price the banks and other institutions are willing to pay to borrow your money has gone down. Similarly, periods of high interest rates are considered bad for stocks because safer investments earn higher returns. Moreover, the interest rate picture is often seen as an indicator for the economy on a large scale. High interest rates mean it is more expensive for businesses to borrow money to expand and will also likely decrease consumer spending.

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