Interest Rate Changes
It is difficult to know some times what interest rates are from time to time because it can be one rate for a car loan, another rate for a mortgage loan and a completely different rate for a savings account. Of course all of that is related to the federal interest rate, but the question remains how are the all connected. Well, it is all controlled in the United States by the Federal Reserve which is the central banking system of the United States. The federal reserve has a number of duties including setting the monetary policies for the country, regulating the banking policies of the country, upholding the stability of the country's financial system and offering various financial services to banking institutions across the country. All of this allows the Federal Reserve to control the movement of money. However, what the Federal Reserve may be best known for is setting interest rates and instituting interest rate changes.
What are Interest Rates?
Interest rates are basically the amount of money a bank will charge you to borrow money. Or, in the case of interest earned on a savings account, it is the amount of money you earn for allowing the bank to borrow your money. Interest is charged just in case the person who borrows the money doesn't pay it back. If you look at a payback schedule for a loan that is borrowed over a set number of years, you will notice that the majority of the early payments made are interest payments. That way, the bank begins getting its money back immediately. By the end of the loan period, the amount you are paying back is the principle which is the base amount you borrowed from the bank.
Federal Reserve Rates
In the case of the Federal Reserve, they control the interest rates charged from bank to bank and from the Federal Reserve to banks. They can do this by either selling or buying government-backed securities. If they buy government-backed securities in large amounts, this will put a large amount of cash into the money system which will drive the interest rate lower. If they sell a large number of government-backed securities, that will take money out of the system which will drive interest rates higher. Either action will have an affect on two kinds of interest rates, the federal funds rate and the discount rate. The federal funds rate is the interest rate banks charge each other when they borrow money from bank to bank. The discount rate is the interest rate the Federal Reserve charges banks when they borrow money from the Federal Reserve. Meanwhile, the interest rate for personal or business loans is referred to as real interest rates.
The whole reason the Federal Reserve does all of this is to keep the economy going and growing but at the same time to keep inflation low. The lower the real interest rates, the better off the economy in general because then people can take out loans to buy homes, cars and other big ticket items. However, the more people spend, the more the demand for items goes up and as demand goes up, so do prices which causes inflation. When inflation begins to increase, the economy then starts to slow down, prices are too high for people to afford and demand slows down which means less production is needed which then results in unemployment. It is a vicious cycle.
In response to this, the Federal Reserve will then raise interest rates. The impact of those higher interest rates is that it strengthens the dollar in foreign markets. Foreign investors are looking for ways to make more money so they will invest in the U.S. markets because they can now make more money on their investments because of the higher interest rates. The increased demand for the dollar then makes the dollar more valuable. Then another vicious cycle has begun. Foreign investors will begin to taper off because it takes more foreign dollars to buy into U.S. investments.
However, now that the U.S. dollar is strong, U.S. investors begin to look to foreign investments so that they can get a better return on their investment. It also increases the level of competition between American goods and foreign goods. American investors are looking outside the U.S. for investment opportunities and sometimes, they find better deals abroad. The problem with that is domestic companies that need investors can't get the liquidity they need which means they may need to make cutbacks, layoffs or go out of business. This can all change however with a change in the federal funds rate. If it is lowered, it signals to investors that the better investments are domestic ones and instead of looking to foreign deals, they consider deals closer to home. That is what makes the job of the Federal Reserve so tricky. So, if Federal Reserve Chairman Ben Bernanke says anything that hints to a change in interest rates, the markets scramble. That is just how sensitive the banking system is. Interest rates are what helps control the U.S. monetary policy which is linked to the U.S. and world economy.
Federal Funds Rate
As discussed earlier, the federal funds rate is one of the interest rates controlled by the Federal Reserve. It is the interest rate banks charge each other when they borrow money. This rate is determined by the amount of risk associated with the loan. A bank with a large cash reserve can get a lower interest rate than a bank with a lower cash reserve. So, if the Federal Reserve lowers the federal funds rate, banks will be able to lower their own interest rates because borrowing money cost them less.
Discount Rate
The discount rate is the interest banks pay when they borrow money from the Federal Reserve. The discount rate is generally a higher rate than the federal funds rate and it is given for very short periods of time, about 24 hours. That is because the Federal Reserve would prefer banks to borrow money from each other.
