What Role Do Interest Rates Play in the Economy?

Central banks, like the U.S. Federal Reserve, use interest rates as a tool to either stimulate the economy or cool it down. When the economy is slow, they might lower interest rates to encourage borrowing and spending. When there's overheating or high inflation, they might raise rates to slow down borrowing and spending.

When interest rates are low, it becomes cheaper for consumers to borrow money. This encourages spending on big-ticket items like homes, cars, and appliances, as well as smaller purchases financed by credit cards. Conversely, higher interest rates can deter borrowing and thus decrease consumer spending.

Low interest rates make it less expensive for businesses to borrow to finance expansion, research, or capital expenditures. High interest rates can deter businesses from taking on new projects because the cost of financing is higher.

Interest rates directly influence the housing market. Mortgage rates tend to rise and fall with prevailing interest rates. When rates are low, it's cheaper to finance a home, which can increase demand for homes. When they're high, monthly mortgage payments may become unaffordable for many, leading to decreased demand.

Lower interest rates can make bonds and other fixed-income investments less attractive compared to stocks. This can lead investors to shift their money to the stock market, driving up stock prices. Conversely, when interest rates rise, bonds might offer a more competitive return, causing some investors to shift out of stocks.

The interest rate level can affect the attractiveness of holding a country's currency. High interest rates might attract foreign capital looking for the best return, which can drive up the currency's value. A stronger currency can make a country's goods more expensive for foreign buyers, potentially reducing exports.

When interest rates are higher, people might be more incentivized to save money because they get a better return on their savings. When they're low, there's less incentive to save, as the opportunity cost of spending is reduced.

Banks generally make money from the spread between the interest rates they pay on deposits and the rates they charge on loans. Depending on the structure of their liabilities and assets, changes in interest rates can impact their profitability.

Over time, interest rates can also be influenced by inflation expectations. If investors expect higher inflation in the future, they may demand higher interest rates to compensate for the decreased purchasing power of the money they'll be repaid in the future.

Governments borrow money by issuing bonds. The interest rate or yield on these bonds is a measure of the cost of debt for the government. When interest rates are low, it's cheaper for governments to borrow, which can impact fiscal policy decisions.

Interest rates serve as a critical mechanism in the transmission of monetary policy and have wide-ranging effects on various aspects of the economy, from individual decision-making to macroeconomic growth and stability.

The Fed makes decisions on interest rates based on its dual mandate, which includes:

1. Maximizing Employment: The Fed aims to ensure that as many people who want to work can find jobs.

2. Stabilizing Prices: This means keeping inflation – the rate at which prices rise – at a target level. The Fed has stated that it aims for a 2% inflation rate over the long term, viewing this level as indicative of a healthy economy.

To determine whether to raise, lower, or keep interest rates steady, the Fed examines a plethora of economic indicators and engages in extensive research and analysis. Some of the primary factors and data it considers include:

Core inflation rates, the Personal Consumption Expenditures (PCE) index, and the Consumer Price Index (CPI) are closely monitored. If inflation is rising faster than the target, the Fed might consider raising rates to cool down the economy.

This includes the unemployment rate, the labor force participation rate, and wage growth. A very low unemployment rate might suggest the economy is overheating, which could push the Fed to increase interest rates.

If the economy is growing too quickly, it might cause inflation to rise. Conversely, sluggish growth might be a sign that lower interest rates are needed to stimulate activity.

While the Fed doesn't target stock market levels, it does pay attention to overall financial conditions, including equity prices, bond yields, and the state of credit markets.

Global events, from economic slowdowns in other major economies to crises or significant policy changes, can influence the Fed's decision.

Surveys that gauge how optimistic or pessimistic consumers and businesses feel about the future can offer insights into future spending and investment trends.

The Fed uses various models to forecast future economic conditions. These models can provide guidance on how changing interest rates might impact the economy.

The U.S. is divided into 12 Federal Reserve Districts, each with its own regional bank. These banks provide data and insights about economic conditions in their respective regions.

The Fed also considers how the public and financial markets expect it to act, as well as the potential impacts of its decisions on expectations for future inflation and economic activity.

During the Federal Open Market Committee (FOMC) meetings, members discuss these factors and come to a decision on interest rates. The decision-making process is based on a consensus model, and while individual members might have differing views, the goal is to make decisions that are in the best interest of the broader U.S. economy.

The Federal Reserve’s decisions on whether to raise to lower interest rates can have a significant impact on both the economy and financial markets, but at any given time, there can be a host of other factors at play. If you are interested in consulting with a financial advisor to determine how the economic environment could affect your portfolio, contact Chicago Partners to set up an introductory meeting.