A Guide to Federal Interest Rates

Changing the level of federal interest rates is one tool that the Federal Reserve Board (FRB) can use to control the money supply and, hence, the growth rate of the economy. An easy way to understand the relationship between the money supply and economic growth is to think of interest rates as the price of money. By raising interest rates, the Fed is raising the price of money. This discourages capital borrowing by new and existing firms to fund growth and provides incentives for consumers to save rather than spend. These two consequences of higher interest rates result in a contraction of the economy, whereas lowering interest rates would lead to greater capital borrowing and more spending, which speeds up the economy. The Fed raises rates in order to smooth out economic cycles when the economy is growing too fast and lowers rates when economic growth is stagnant and needs stimulation.

Goals of the Fed and Causes of Inflation

The primary goal of the Fed is to maintain a low, steady rate of inflation. This will allow for stable prices in the long run. In the United States, this is done by basing the target federal funds rate (the overnight bank lending rate most commonly used by the Fed to control monetary policy) on the current performance of the economy. This requires an accurate estimation of the potential GDP, which is the level of economic performance achieved when the economy is operating at full employment. If interest rates are lowered (and demand increased) when the economy is operating at full employment, the effect will be temporary because the cost of money wages will rise and firms will reduce supply, increasing prices so that the relationship between price level and full-employment (real) GDP remains in equilibrium. If the Fed continues to lower rates at the real GDP level, inflation will occur. Inflation can also occur if the Fed continually lowers rates at full employment, which will continually reduce supply, causing a supply shock (as seen during the oil crisis of the 1970s).

Interest Rates on the Market

With regard to equity markets, interest rate changes will have different effects on different sectors. Industries that rely on large amounts of capital borrowing (e. g., utilities) will be more sensitive to interest rate fluctuations than industries that are not as capital intensive. Lower interest rates will bode well for industries such as the automotive industry because lower financing costs will encourage buying.  In general, when interest rates rise, the required returns on stock investments increase because stock returns have to compete with higher-yielding and less-risky bond returns.

The Role of Expected Inflation

Expected future inflation also plays a considerable role in consumer and investor behavior. If inflation is expected to rise in the future, investors will require greater rates of return because they are considering the trade-off between current and future consumption. This lower supply of savings coupled with an increase in the demand for financial capital (expected higher interest rates cause firms to demand more current financial capital) will increase nominal equilibrium interest rates. 

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