Money and interest rates

Money & Interest Rates

If I was undertaking a large purchase on credit I would want to pay attention to a few of the economic indicators. For the most part, these indicators would focus on the ones that impacted interest rates. These include savings rates, inflation rates, and demand for funds in the economy.

Inflation is an important measure because the Federal Reserve is usually focused on using interest rates to head off inflationary pressure. The main measure of inflation is the CPI, or specifically the core CPI. The CPI, consumer price index, is a measure of the cost of a standardized basket of goods. The core CPI is the regular CPI but excluding food and energy prices. While those prices account for a large portion of consumer spending, they are also highly volatile. Increases in the CPI are typically indicative of building inflationary pressure, which would indicate that interest rates may rise in the future. At present, the core CPI is decreasing, indicating that there is little inflationary pressure. The markets also reflect the inflation risk in the U.S. dollar. This measure can be found in the rates on U.S. debt, in particular 10-year debt. Rates on 10-year debt around at 3.12%, right around the 3% historic rate noted by Woodruff.

Savings rates are part of the basic GDP equation, along with aggregate demand in the economy. When aggregate demand is low, interest rates are typically low. This was seen during the recent recession, when aggregate demand declined. Interest rates were lowered in an attempt to stimulate the economy. As the economy recovers, we already see pressure from some quarters to increase interest rates to ward off inflation although the core CPI is still declining. The Federal Reserve should wait until inflationary pressure begins to form, then increase rates. So for the observer, it is important to watch for indicators that inflationary pressure is forming, such as upticks in aggregate demand, decreases in unemployment and decreases in savings rates. The market will also indicate its concerns about risk in the rates on U.S. bonds. While savings rates have declined from their highs, this is the only indicator that has moved strongly towards the creation of an inflationary environment; therefore a rational investor would conclude that rates are likely to remain low for the next year or two, barring the emergence of genuine inflationary pressure.

2. The Fed's policy makers influence interest rates in a couple of ways. The first is directly, by setting the Fed Funds rate, or the rate at which banks lend to the Fed, which is also the interbank rate. This rate impacts the cost at which banks can lend and borrow, so ultimately influences the rates at which banks lend to their customers. The lower the rate, the more people will want to borrow, so the lower the rate the more money is in the economy.

The Fed can also influence interest rates in its statements. The statements are produced when the Open Market Committee meets. Even if rates do not change, the statements will express the views of the members of the OMC and often hint at future rate changes or directions of Fed policy. Other guidance reports may discuss specific approaches to policy that could hint at future rate moves. The markets process these reports and use their findings to help set future rates.

The interest rates on U.S. debt are set by the demand for this debt. The Fed therefore uses open market operations in order to increase or decrease the interest rates on U.S. debt, using its targets in mind. To lower rates, for example, the Fed will spend its money buying U.S. treasuries. This has the affect of increasing the prices on those instruments, which will have the effect of lowering the yield (rate) on those same instruments (the Economist, 2007).

3. Prospects for a change in Fed policy would not likely affect my decision to make a purchase that requires financing. The decision will be based on a large number of factors, price just being of those factors. There are two other things to consider. The first is that Fed policy can be assumed to be built into the markets. Prices in liquid markets are based on the best possible public information. Therefore, if I know about the pending change in the interest rates, that is public knowledge and will already be priced into the market rates. Any speculation I may have about interest rate changes is probably based on less information than what the market is already using, therefore my prediction has a lower likelihood of success; in case it is merely gambling to speculate.

The other consideration is that while changes in the interest rates may not impact the decision to purchase, they may impact the timing of the purchase. A house bought in 2006 when prices and rates were high would have been a much worse investment than the same house purchased in 2009 when prices and rates were low. Conversely, if expectations today are that rates will begin to rise in the next year or two then a major purchase now would be prudent; waiting could see the cost of that purchase increase significantly. In any case, the rate may impact the timing of the purchase but not likely the decision to purchase, unless the purchase was strictly as an investment with no other criteria attached.

4. In the current economy, rates are at the zero bound. However, the Fed still has the same tools in its arsenal for influencing interest rates. The Fed can increase rates if it believes that inflationary pressure is mounting. It has not done so because there is no evidence of inflationary pressure. The Fed cannot lower rates at this point, but that does not mean that it no longer has this tool, it means that it has used this tool. The Fed can also make statements with respect to its views of the state of the economy. If those views have concerns about inflation embedded, the market could take that as a sign of impending rate increases.

Addressing the economy as a whole is more complicated. The Fed is not the sole actor responsible for the state of the economy, which is good because it has very limited tools to address the economy. Interest rates are its primary tool, and it has used that tool to its fullest. Maintaining those low rates will encourage spending and investment, which will in turn help to drive the economic recovery. However, it is clear that low rates alone will not address this problem.