Financial Literacy

A Primer on Interest Rate Effects

Go to any financial news site (or poke around our archives), and you’ll find lots of interest rate talk.

One week, stocks are down because the Fed implied a rate hike is coming soon. The next week, a new report comes out that suggests the opposite. As a result, the markets take off.

Amidst all of this back and forth, you might be struggling to remember what the Fed’s interest rate actually does. If you need a brief economics refresher, read on.

Let’s start with some basic concepts. When we’re talking about the Federal Reserve interest rate, we’re talking about the federal funds rate or policy rate.

Think of the Fed itself as a bank for banks. You know how you can deposit money and apply for loans at your local bank? That local bank deposits money at the Fed. It can borrow from the Fed, too. The set interest rate used in these transactions is the federal funds rate.

This rate “trickles down” through the banking system to affect just about everyone. Here are some of the things it does…

Lending vs. Borrowing

The most elementary effect of the fed funds rate is on lenders and borrowers. When the policy rate increases, it drives up other interest rates.

That’s good news for lenders. Mortgage-issuing banks can make more money in a high-interest environment, since they’re charging interest on home loans.

Inversely, a low policy rate (like we have now) is great for borrowers. To use the same example, home-buyers can currently get a great deal on mortgages because rates are so low.

The coming policy rate hike will change that situation. It’ll make it a bit more costly to borrow money for a house or vehicle. But, at the same time, it will end the profit rut that mortgage providers have been in for the last few years.


Saving vs. Investing

Interest rates also influence what people do with their money. A high policy rate boosts regular bank interest rates, including the one on your savings account.

Thus, high interest rates make it profitable to save more.

Low interest rates, on the other hand, provide less of an incentive to sit on your money. A low policy rate drags down bank rates.

That encourages people to move their money around by spending and investing it. Which is why the stock market has been moving inversely to the probability of a policy rate hike. The graph below shows an example.

interest rate effects

This is also why the Fed has kept rates so low since the Great Recession.

Low rates are supposed to boost spending and increase the supply of actively circulating money. The idea is to use low-interest lending as a stimulus policy during this awkward recovery.

The Bond-Price Seesaw

Changes in the policy rate also directly affect bond prices. But the mechanism for this is a bit counterintuitive…

When interest rates go up, fixed-rate bond prices go down. It’s a seesaw relationship. If you’re wondering why, the key words here are fixed rate.

A basic example: If you have a bond which yields 2%, and then the Fed announces a rate hike up to 4%, then that means new bonds will yield twice as much as your old bond. Thus, no one will want to buy your old, low-rate bond – and its price will fall.

Inversely, if you have a 2% bond and then the policy rate drops to 1%, you now own a rare and valuable antique of a bond. Your bond will yield twice as much as new bonds. So everyone will want to get their hands on it, and the price will increase.

The latest news on interest rates is… mixed. Fed Chair Janet Yellen made remarks at the Jackson Hole conference that implied a rate hike could happen soon. But just days later, a disappointing jobs report put a damper on that hawkishness.

(Investors hoping for some clarity from the Fed shouldn’t hold their breath, either. We dug into the internal conflict between Fed members here.)

In the meantime, if you want to learn how Marc Lichtenfeld is utilizing near-zero rates to his investment advantage, check out this recent article.

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