A Guide to Interest Rates and How It Affects the Economy

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.

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.

Why do interest rates matter?

Interest rates matter as they affect the economy in many ways. The primary one is that they influence borrowing costs. 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.

What are the reasons for increasing 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[1] for several different reasons.

• 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. 
• 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% [2]. 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.