If you have paid any attention to the economy over the last couple years, or even just considered getting a loan, you have heard a lot about interest rates. For the average person though, it can be confusing to understand what rates we are talking about, who sets those rates, and why they have had such a huge impact on the economy. We hope to demystify the whole situation for you today.
What interest rates?
When the term “interest rates” comes up, it can mean one of two things depending on the context.
Bank Rates
The first is what we will call “bank rates.” This is the general rate that banks and lending institutions are currently charging on new loans or paying on savings deposits. If your friend is complaining about not being able to afford a mortgage payment because of interest rates, or your Grandma is cheering about how much money she’s making on her CDs at the bank, they are referring to bank rates.
These rates vary by each financial institution because each one gets to decide what they will charge or pay in interest. However, the rates they choose for savings and lending are heavily influenced by the “discount rate”, which is our next topic.
The Discount Rate
The discount rate is the rate at which banks and credit unions can borrow funds from any of the Federal Reserve Banks (also known as the Fed). Believe it or not, most lending institutions don’t rely exclusively on their deposits to fund new loans. They borrow funds from the Fed to fund your loan, charge you a higher rate of interest than they pay, and keep the difference as their profit.
The body of government that sets the discount rate is called the Federal Open Market Committee (FOMC), which is currently led by Jerome Powell who is the Federal Reserve Chairman. His position is nominated by the U.S. president and confirmed by the Senate to serve four-year terms.
So, if you’ve heard on the news that “the government is raising rates”, you can know they are talking about an increase to the discount rate by the Federal Reserve.
How does the Discount Rate affect the economy?
The first clear impact is in the cost of borrowing money for everyday Americans. When the pandemic hit in 2020, the FOMC lowered the discount rate to nearly 0%. As a result, the money borrowed by banks for new loans was incredibly cheap and they started to pass on those savings to their customers in the form of super low interest rates on all kinds of loans. Due to the increased access to easy money for banks, they no longer needed as many savings deposits to fund loans and dropped the rate at which they pay interest to their depositors.
In 2022, when the FOMC started to raise the discount rate, it had the opposite effect. Borrowing became more expensive for banks, which was passed on to the customers in the form of higher loan rates, and they needed more deposits to fund loans which turned into higher rates paid to depositors. This is what we are seeing today with mortgage rates pushing 8% and deposits earning close to 6% interest. Contrary to what some might think, the banks need to charge more interest now to be able to make a profit on these loans. They aren’t just “being greedy” and taking advantage of the “little guy.”
Higher rates also mean that current bond or debt investments that had been paying lower rates are less desirable than the new ones that pay more interest, which causes those older bonds to decline in value. Considering the fact that the majority of all investors have at least a portion of their accounts made up of bonds, it has contributed to significant investment declines.
In addition to the impact on consumers, the cost of borrowing money has an impact on businesses big and small. Innovation and new business ventures are much more appealing to fund when the cost to repay them is lower. Less business lending means money is tighter, possibly leading to hiring freezes, and the risk taking needed to spur growth is less likely.
Why raise the Discount Rate then?
After reading that last section, you may be wondering why in the world the FOMC would ever raise the discount rate if they wanted the economy to do well. Well, the short answer is inflation.
One definition of inflation is too much money chasing too few goods. When that happens, prices rise to account for higher demand. During 2020 and 2021, we saw rates of inflation at 40-year highs which increased household costs and eroded the value of savings.
Part of the Federal Reserve’s purpose is to keep inflation under control, so when it started to spiral, they took action with one of the only tools at their disposal, the discount rate. Increasing the cost of borrowing in turn decreases the amount of money circulating in the economy. And when there is less money chasing the same amount of goods (see our definition of inflation earlier), the rate of inflation goes down.
So, what happens now?
Since the start of 2022 when they started rate increases, we have seen it have its intended effect to bring down the rate of inflation. After hitting a year over year high of 9.1% in June of 2022, inflation reached a recent low of 3.0% in June of this year. This is a sign that the higher rates strategy has been working and getting closer to the Fed goal of 2% inflation, however, the next couple months came in at 3.2%, 3.7%, and 3.7%.
Fed Chairman Jerome Powell recently commented on this trend and said, “Inflation is still too high, and a few months of good data are only the beginning of what it will take to build confidence that inflation is moving down sustainably toward our goal.” Based on these comments and other remarks in regular press conferences, we believe the Fed plans to keep rates pretty steady at this higher level for quite some time. That could be for about a year, or maybe even longer. If inflation continues to show steady numbers well above 2% then it’s possible rates could go slightly higher, but at the same time the Fed has communicated that they don’t want to crash the economy with too much stress from the rates.
If you are waiting around for rates to drop, you may have to be patient. Even if the Fed does decide to lower the discount rate, it may be just as gradually as they raised them. In the meantime, if you’d like to stay up to date on interest changes and inflation trends, subscribe to our free monthly newsletter above by clicking “About”, “Newsletter”, and then the subscribe button.
On the other hand, if you want to create a personalized strategy for how to plan and invest through the ups and downs, give us a call, or schedule a free consultation by clicking “Schedule Appointment” above.
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Sources:
https://www.nasdaq.com/market-activity/fixed-income/disc/historical