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Defining Interest Rates

An interest rate is the percentage of the loan amount the borrower has to pay back to the lender. Interest is charged because the lender could have saved or invested their money, instead of giving it to you. The lender expects a fee for their service.

Interest rates are all round us. Individuals, Businesses, and governments all have to pay interest on money they borrow. There are various types of loans that have interest.

• An example of a consumer loan is mortgage (A loan for a house)
• Businesses take out loans from large commercial banks and investors to help grow their operations
• Governments take loans from other countries, as well as their own citizens (Bonds)

Interest rates in the Macro-Economy

In most countries, the central bank manages monetary policy, which includes setting interest rates. The central bank aims to minimize the fluctuations in the business cycle, and achieve steady upward economic growth.

The U.S. central bank is the Federal Reserve. The goal of the Federal Reserve, also known as the “Dual Mandate,” is to maximize employment, and maintain stable prices.

The Federal Reserve is technically separate from the U.S. government. The President and Congress are not in charge of interest rates.

The Fed meets 8 times a year to set the range for the FFR (Details)

As seen in the graph, the federal reserve lowers interest rates during recessions, and raises them when the economy grows. The former is known as expansionary policy while the latter is known as contractionary policy.

Expansionary Policy:

• Consumers will buy more, as it is cheaper to borrow money
  • Lower rates on credit cards
  • Lower rates on mortgages
  • Lower rates on personal loans
• Businesses will invest more, as it is cheaper to borrow money
  • Hiring new workers
  • Building new factories
  • Researching new products or services
• Increased economic Growth
• Inflation increases, and price level for all goods increase at a quicker rate as a result

Contractionary Policy:

• Borrowing is more expensive, so consumers borrow less
  • Higher rates on credit cards
  • Higher rates on mortgages
  • Higher rates on personal loans
• Businesses will invest less, as it is more expensive to borrow money
  • Cutting jobs
  • Selling factories
  • Cutting investment into research and development
• Decreased economic growth
• Inflation decreases, and price level for all goods decrease at a slower rate as a result

Interest rates in the Micro-Economy

Although the federal funds rate affects consumer interest rates by setting the “baseline” rate. However, banks still need to make money, and they charge customers additional percentage points based on their credit score.

The most creditworthy customers get charged what is known as the prime rate. The prime rate is directly influenced by the federal funds rate (usually FFR+3%). Less credit worthy customers get charged higher rates, as they are deemed to carry more risk to the lender. The higher risk the lender takes, the more interest they make.

The most common creditworthiness model is a FICO credit score. The closer you are to 850, the more likely you are to pay a a rate near the prime rate.

How Do Rates Effect the Stock Market?

How do interest rates have such a major effect on the stock market?

Under expansionary policy, stock market performs better for a few reasons. One reason is because savings accounts, bonds, and CDs pay out very little interest. In 2020 wen rates were near zero, most commercial savings accounts were paying out <1% per year. Seriously?

People are feeling optimistic and risk-tolerant. In return, they are investing more money into the stock market. As a result, businesses then take this money, and grow their company at an increased rate.

Under contractionary policy, the stock market generally underperforms for a few reasons. Bonds, savings accounts, CDs, return much higher. The 10-year US Treasury Bond Note Yield was 15.82% in September 1981. That’s a risk free return that almost doubles the average return of the stock market.

With fewer people going out and shopping, businesses now have less money to invest back into themselves, and as a result they have less money to grow themselves.