Changes in interest rates can have both positive and negative effects on markets. Central banks often change interest rates as a response to how the economy is performing. If the economy is overly strong, rates will often get raised. In a weak or sluggish economy, rates are lowered to stimulate growth. Interest rates also affect both direct and indirect parts of our personal lives. Some of the direct implications are demonstrated through the costs we pay for goods and services and the lending rates we are offered. Let’s examine why:
The Federal Reserve controls the federal funds rate which is the rate at which commercial banks can lend their reserves to each other. A bank’s reserves describe the cash that banks must keep in actual vaults to make sure they have enough liquid money to satisfy a large withdrawal. Why is this important, because the federal funds rate also affects things like unemployment, economic growth, and inflation in the U.S.
The federal funds rate affects other interest rates as well, such as interest rates on home or auto loans. Why does this relationship exist? Because the interest rate at which you pay back your car loan depends on the bank’s individual rate for you (this is known as the prime lending rate,) and your individual rate is directly related to the federal funds rate.
What it means when the Fed is going to ‘reduce its balance sheet’ and ‘raise rates.’ When the federal funds rate is low, it encourages people to invest or take out loans (because you have less interest to pay back.) That’s one of the main reasons the Fed lowered rates during the pandemic, to incentivize people to participate in the economy. The Fed also began buying bonds and other securities thereby increasing the size of its balance sheet. This process is called quantitative easing.
Quantitative easing is an unconventional monetary policy in which a central bank purchases longer-term securities from the open market in order to increase the money supply and encourage lending and investment. Buying these securities adds new money to the economy and serves to lower interest rates by bidding up fixed-income securities. It also expands the central bank’s balance sheet.
Although lowering rates and increasing asset purchases is an appropriate short-term monetary response to a pandemic-era economy – low rates, and printing lots of money causes inflation in the long run, which is where we are now. So, if raising rates helps combat inflation, why does the stock market react negatively? Because higher interest rates raise borrowing costs, disincentivizes hiring, increases credit card rates, and generally slows down the economy (at least, temporarily.) When economies slow down, bonds become more appealing investments because they’re less risky.
Hopefully this post gives you a general idea on not only what interest rates are, but an understanding of some of the ways they can affect our planet, our country and even our daily lives. The next time you hear about interest rates going one way or another, it should ring a bell as to what comes next…