Interest Rates Here & Interest Rates There… So What?

By Eric Iacob

The global pandemic in 2019 has once again exposed the public  to the Fed’s favorite term (outside of  Quantitative Easing): interest rates.

The vast majority of the population sees interest rates as a factor influencing their ability to borrow from commercial banks; however, those unfamiliar with interest rates fail to acknowledge the significant power that interest rates have in dictating the amount of growth- or lack thereof- of the United States’ economy and its GDP.

What are interest rates?

The core definition of interest rate relates to the time value of money. Typically, interest rates are most commonly regarded when it comes to loans and mortgages, which ultimately urge that the individual taking on debt returns a specified percentage of the principal amount borrowed over the course of a mutually established period. On the other hand, investors deem interest rates in terms of the percentage that banks charge other banks for money borrowing- the percentage charged for lending large sums of funds to investment firms (e.g. private equity firms, hedge funds, etc.). Since both investors and consumers determine their investing and spending habits depending on the state of interest rates, the economy moves in tandem with those decisions. Higher interest rates prompt less investing and consumer spending, resulting in slowing down GDP (i.e. economic) growth. Simply put, interest rates have a major effect on the investing and spending categories of the U.S.’s GDP, directly affecting the direction the economy is headed in.

How are interest rates utilized?

The Federal Reserve (The Fed) can directly influence interest rates through its expansionary and restrictive monetary policies. In other words, the Fed manipulates interest rates according to the amount of economic expansion that it seeks; this is done through the Fed’s ability to print the U.S. dollar, as well as setting the level of interest for its Federal Funds Rate – the interest rate it charges banks for borrowing money. When the economy is “overheating” or expanding too quickly, the Fed, unless it chooses to engage in quantitative easing, will proceed to raise the federal funds rate as a means to limit the amount of borrowing and lending in the economy; this slows down the rates of inflation. On the other hand, the Fed will lower interest rates, all the way until they’re effectively zero- as seen during the pandemic- to stimulate the economy through increasing lending activity.

How have interest rates changed?

Interest rates have fluctuated across history, reaching all-time highs such as 17% during the 1980s, and lows close to effectively zero since the COVID-19 pandemic. Investors became especially concerned with the particularly low recent interest rates due to the overwhelming inflation they have caused, accelerating all the way to 7.9% in February of 2022. This was primarily attributable to the significant rise in used-cars prices, energy rates, and produce. Essentially, the higher the inflation, the lower the purchasing power of a dollar, which means that less can be purchased for the same dollar amount. With this occasion, it wasn’t until recently after the March 15-16 meeting that the Federal Reserve announced that it will be raising interest rates 0.25% higher, after which multiple rate hikes are expected to come. Now, this is certainly not a particularly high increase, but it is a step in the right direction that is becoming increasingly needed. The psychological effects, rather than the increase in interest rates, have the largest effect on economic stability. Often, if the public expects inflation to come and to continue to increase, then the self-fulfilling prophecy becomes reality. Otherwise, inflation is contained. Thus, the Fed’s decision to finally hint at its ability to stabilize inflation will render the public more confident moving forward, preventing any irrational fear that might’ve occurred otherwise.

Why should you care about interest rates?

Interest rates affect everyone’s daily lives. For one, borrowers should consider the state of interest rates to determine whether it is wise to take on an extended mortgage- or any other type of financing- immediately or perhaps delay it until a more advantageous date. Equally important, investors follow interest rates closely to determine the direction of their potential investments: investors usually seek large amounts of capital in the form of debt in order to finance their investments, and their interest expense is directly related to their debt’s established interest rate. Besides the financial wisdom that following interest rates allows for, everyone should be closely in touch with the current rates in order to gauge the state of the economy. Thus, whether it is following the Fed’s monthly meetings and announcements, or reading market and economics journals, the public should absolutely be up-to-date with interest rates.