Good morning & happy Monday!
“Learn how to see. Realize that everything connects to everything else.”
Leonardo da Vinci
Interest rates affect virtually every component of the financial landscape.
Because this is such a critical issue I would like the opportunity to provide a little more insight into this fascinating topic … ok, it’s fascinating for me, it might be a snoozefest for you 😉 I’ll try to be relevant and as brief as I know how.
First of all, who determines the interest rates? Is it the government? Yes. Is it the market? Yes.
Let’s dive in.
The Federal Reserve Bank is the central bank of the United States and they are tasked with providing the nation with a “safe, flexible, and stable monetary and financial system.” The Board of Governors for the Fed is Jerome Powell, and they have 8 regularly scheduled meetings per year where they announce the interest rate they set. This is the rate they lend to the banks across the country and in turn what banks lend to their borrowers. This is how the government has a say in the interest rate environment.
Now, the market forces of supply and demand are also at work in the interest rate environment. For example, if a company were to issue a bond offering of $100,000,000 for 10 years at 5% and they found tremendous demand for that bond they might only have to pay 4.75% to get all $100,000,000 of the bonds issued. Demand is high so they can pay a lower interest rate. The opposite could also be true, if demand were low, they might have to pay 5.25% to get the entire bond offering issued. This is an example of market forces driving the interest rates.
We having fun yet? 😉
Now, virtually everything in the economy is tied to interest rates in some capacity.
To illustrate this, let’s go to the example above about that company issuing $100,000,000 of debt through a bond issue. On $100,000,000 the difference between 4.75% and 5.25% is $500,000 per year of interest. So, if the demand is high enough for the bond issue, the company could save $500,000 per year in interest on this bond issue alone. This could have a significant impact on the company’s bottom line profit.
Let’s go just a bit deeper for those of you who are still awake. 😉
Let’s move into the extremely depressing topic of the United States debt, which currently sits at over $34.6 trillion. That’s $34,600,000,000,000! The interest payments alone are projected by the CBO (Congressional Budget Office) to be $870 billion in 2024. $870 billion is about 2.5% of $34.6 trillion. If the interest rate were to increase from 2.5% to 3.0% then the interest paid by the government (AKA: you and me) would be $173 billion more per year! The population of the U.S is around 333 million as of 2022. That 0.5% increase in interest on the U.S. debt would cost $173 billion more in interest per year, which equates to $519 more interest for every single man, woman, and child inside our country every single year!
Getting an idea on how important interest rates are? 😊
Let’s take one more look at how interest rates affect the economy, but this one gets more down to the individual level.
At the start of 2022 the average 30-year mortgage rate was 3.11%. Today it sits around 7.50%. That’s a significant increase, but let’s see how that plays out.
If I were to take out a $500,000 mortgage a few years ago and pay a 3.11% interest rate my monthly payments would be $2,138/month (not including taxes & insurance).
Today that same $500,000 mortgage would cost me $3,496/month (not including taxes & insurance) with an interest rate of 7.50%.
That’s a payment increase of $1,358/month! That’s $1,358/month I don’t have to go out to the movies, or go out to dinner, or take a trip.
When consumers are spending more on interest that means they go out to eat less frequently … which means the restaurant owner has less sales … which means she doesn’t buy that new car … which makes the car salesman have less money and he cancels the trip to the beach … which lowers the income the hotel owner has … which means he does not do the hotel remodel … which means the contractor does not get that job so he has to lay off some of his employees … which means those laid off employees now massively cut back on their spending at Wal-Mart … which reduces Wal-Mart’s income and profit … which means Wal-Mart buys less toys from the toy company … and on and on and on it goes. It all ties back to interest rates.
An increase in interest rates generally slows down consumer spending (more money going to interest and thus less for other things), and a decrease in interest rates generally increases consumer spending (less money going to interest means more money for other things).
It’s a complicated world, and the financial world can most certainly get really overwhelming, but understanding the critical role interest plays in our society I find to be a fascinating topic.
I hope I didn’t bore you too much and that you found this information helpful.
If we can come alongside you to provide any support, please never hesitate to reach out.
I’m so honored to serve you! Make it a great week ahead!