Why You Should Care
For the U.S. consumer, the sort of stagflation caused by oil shocks or similar shortages creates the most concern. If you see inflation in the economy, particularly energy and food prices, that should not be taken as signs of a robust economy; more likely, the economy will sink as higher prices sap the strength, like a tax, of the economy. If the government tries to deal with these effects by tightening the money supply, look out—especially if you’re in an economically sensitive vocation.
The good news: the sort of stagflation caused by regulation or economic inefficiencies is less likely to happen in the United States than elsewhere. Despite what it may seem like sometimes, the U.S. economy is considered to have one of the easiest and most consistent regulatory climates of any developed country. This is why many economists are concerned when they hear cries for more regulation, and why they became concerned with some of the proposed policy changes that came with the recent economic crisis—they want to preserve the “stable state” the United States offers for capitalist commerce.
21. INTEREST RATES
An interest rate is the price a borrower pays to borrow money. The key word is price—for whatever reason, possibly owing to the negative references to the borrowing and lending of money in the Bible, the concept that interest is a price paid for the use of something, in this case, money, is poorly understood by most. If you think of interest rates as a price, sometimes too high, sometimes a bargain, you’ll learn to make better decisions when evaluating a borrowing opportunity.
From your point of view, interest rates are a price, or cost, of using money. They are also the price, or benefit received, for letting someone else use your money, as in when you deposit money in a bank or buy a bond. Finally, on a national scale, interest rates are also a vital tool used by governments to control money supply and the availability of credit, and thus to exert some control over the economy.
What You Should Know
Interest rates are normally expressed as a percentage of a borrowed balance over the period of one year. Many interest rates are quoted as a nominal, or ongoing, interest rate, with an “annualized percentage rate” quoted in parallel to account for all borrowing costs, including fees, associated with a borrowing transaction, on an annual basis. Federal law requires publication of APRs to allow simple “apples-to-apples” comparisons of the price to borrow money.
The interest rate, or price, for the use of borrowed funds depends on several factors:
Length of loan term. How long will you keep the money you borrow? That will influence the price, because of two things. First is the opportunity foregone by the owner of the money to spend it or invest it in something else. People tend to prefer liquidity—that is, to have their money available to spend. Second is the risk of default or inflation, which increases the longer you hold the money. Under normal circumstances, the longer you hold the money, the more you will pay for it, and if it’s your money, the longer you lend it, the more you can collect.
Inflationary expectations. When inflation is high—that is, money is losing value fast—you’ll be able to pay back with cheaper, more plentiful dollars later. As a result, high inflationary expectations usually lead to higher nominal, or quoted, interest rates, although the real interest rate (interest rate minus inflation rate) may stay the same.
Risk. In any lending situation, there’s always the risk that the borrower will go bankrupt or not be able to pay back for some other reason. As a result, lenders assess this risk, sometimes very methodically, and may charge a risk premium (see #24 Risk Premium), or an interest rate above the going market rate, to account for this risk. A company or government entity with a poor credit rating, likewise, will be forced to pay higher rates.
Taxes. The interest paid by municipalities and certain other public entities is nontaxable, so these entities can pay a lower interest rate and the recipients still come out the same, since they don’t have to pay taxes on the income. As a result, tax-free bond interest rates can be 20 to 40 percent lower than taxable interest rates.
There are literally hundreds of different interest rates in the marketplace for different kinds of loans or securities of different term lengths, risk factors, and tax status. For most people, the following are most important:
BORROWING RATES
Fed funds rate (see #31 Target Interest Rates) as a leading indicator of other rates and general Fed economic policy
Prime rate (see #22 Prime Rate), another barometer of market interest rates
30-year mortgage rate
Credit card interest rates—not because they change but because they can be very costly, as much as 25 percent above “market” interest rates. That’s an expensive price premium.
SAVINGS RATES
Certificate of Deposit (CD) rates, an important form of savings
Money market rates (see #76 Money Market Fund)
Why You Should Care
Interest rates affect all of us directly or indirectly. Directly, they determine how much we pay to borrow money for homes, cars, education, and so forth, and they determine how much income we receive on savings—which has been a big issue for many lately who depend on interest income, especially to fund retirement. Indirectly, interest rates and changes in interest rates can give strong clues to which way the economy is going, and which way policymakers want it to go.
22. PRIME RATE
Not too many years ago, news headlines featured any change in the so-called prime rate. Whenever it changed in one direction or the other, it was considered news. Although it has declined in importance, the prime rate is still used as a benchmark or reference interest rate by banks, economists, and others in the business world.
What You Should Know
The prime rate, or “prime lending rate,” is, in theory, the interest rate banks charged their best, lowest-risk customers. The loans in question were largely unsecured and short term, so the prime rate was a representation of how much the credit was really worth in the marketplace. These days the prime rate is more likely tied to Treasury security rates or to “average cost of funds” figures published by the government; some interest rates are quoted as a percentage above or below the prime rate.
In the United States, the prime rate has typically run 3 percentage points, or 300 basis points for those of you wishing to sound financially sophisticated, above the target federal funds rate set by the Fed.
Why You Should Care
Most people don’t care as much about prime rates as they did ten to twenty years ago, although they are still used as a benchmark for change. Today, the Fed funds rate, Treasury bill and bond rates, and mortgage rates are more broadly accepted measures of interest rates and interest rate direction.
23. YIELD CURVE
Economists and others in the financial community use the yield curve to plot the relationship between yield, or interest rate return, and maturity, or length of time a debt security is held. The most frequently reported yield curve compares the three-month, two-year, five-year, and thirty-year U.S. Treasury debt.
Generally speaking, the longer a debt security is held, the higher the interest rate. That’s because of the greater opportunity costs and the greater risks, including inflation, over the longer time period (see #21 Interest Rates). But depending on economic circumstances and central bank policy, the relationship between yield and maturity can change or even reverse. So economists watch yield curves closely for signs of economic health, and financial professionals watch the curve for signs of preference for different kinds of debt securities, such as mortgage rates or bank lending rates.