The topic of interest rates can be both boring and hard to understand all at the same time. This article will outline high level the different types of interest rates as well as how they work.
The Federal Reserve
First, there are interest rates that are controlled by the Federal Reserve. The lowest rate is known as the fed funds rate which is the rate that banks charge each other to borrow from each other for overnight loans. The next rate is the discount rate which is slightly higher and is the rate that the Federal Reserve charges when they make loans to banks. The next higher rate is the broker rate which is the rate that banks charge brokers. Finally, there is the last and highest rate, the rate that banks charge customers. This set of rates are largely set by the Federal Reserve.
The historical role of the Federal Reserve is to control inflation and maximize employment. If inflation begins to take hold the Federal Reserve is supposed to raise interest rates to keep inflation in check so as to not allow the purchasing power of the dollar to slip. If higher rates of unemployment are taking place – the Federal Reserve would reduce the fed funds rate as a way of trying to spur employment as businesses are encouraged to borrow and employ as a means of growing a business.
The Treasury
Treasury Rates are set to 2, 10 and 30 year levels. The most closely watched is the 10 year. Treasury rates float based on macro economic activity whereas the Federal Reserve rates are controlled by by members of the Federal Reserve board…namely the Chairman or Chairwomen of the Federal Reserve. When the 10 year rate begins to climb the market expects inflation to follow. When the 10 year falls the opposite is true. In general, the rising 10 year rate is seen as a good thing for the economy because it is predicting future growth. However, if it climbs too fast too quick inflation can and will ultimately devalue the value of your money. In these cases the Federal Reserve steps in to lower the fed funds rate. However, this rate has been held close to 0 for a number of years leaving the Federal Reserve very little room to make adjustments.
Great Resources
How To Invest And Profit In A Rising Interest Rate Environment – Financial Samurai
Bonds Are Getting Crushed – The Irrelevant Investor