Good morning & happy Monday!
“Interest rate cuts have an effect in stimulating an economy by directly or indirectly making someone, somewhere spend more than they otherwise would. That extra spending increases demand and ensures that we all carry on with work to do, without us having to slash our prices or our wrists.”
– Evan Davis, British broadcaster & former economist
So, there has been a lot of talk about interest rates recently. I thought we might spend a few minutes discussing interest rates, how vital they are in the economy, and the effects they have on us all.
Here’s the basic thought process:
- High interest rates rewards savers and punish borrowers
- Low interest rates punish savers and rewards borrowers
With this as the backdrop lets dive into how they are set.
The Federal Reserve, who’s current chairman is Jerome Powell, sets the rates that the government lends to banks and thus what banks lend to consumers.
The Fed can use what’s called monetary policy to directly affect consumer behavior. It isn’t instant or a perfect science, but what the Fed sets the lending rate at has a ripple effect across the entire interest rate environment.
If the economy is running too hot, usually meaning inflation is running high (their target is 2% or less) and/or unemployment rate is low (5% or less), the Fed will likely increase interest rates. What does this do? As we just read, it rewards savers and punishes borrowers. In doing so, the American public (people and businesses) will change their behavior in a fairly predictable manner.
Quick example: Let’s say interest rates savings are 4% and borrowing rates are 8% and you are considering a home remodel project at a cost $25,000. Let’s say you have $10,000 in your savings for the project, and are going to borrow the remaining $15,000. Now, if rates go from 4% to 6% on your savings account you will make more interest (making it more attractive to leave the money there) and your loan interest rate goes from 8% to 10% you will be paying much more interest on the loan (making the loan less attractive). You may say something along the lines of, “Forget it, I’m making good interest in my savings, and I don’t want to pay that high of an interest rate on the loan, so I’m going to scrap the project for now.” What you just did in this example is slow down the economy.
You didn’t necessarily intend to do that; you just responded in a natural way to the changing interest rate environment. You didn’t spend your money at the home improvement store, and you didn’t hire the laborer to do the installation. Those businesses slow down their purchases and hiring as a result and the economy slows down … exactly what the Federal Reserve was looking to accomplish with such a policy. This will most likely result in lower inflation and a higher unemployment rate.
We saw this in 2022. Interest rates had been quite low for many decades and then when all the COVID related spending fully hit the economy we saw too many dollars chasing too few goods (the textbook definition of inflation) and prices shot up. At its worst point we saw the year-over-year inflation reading come in at 9.1% in June of 2022. Every single one of us was affected by this.
The Fed rushes in and aggressively raised interest rates. A move very unpopular with borrowers and businesses that carry high debt loads, but a necessary move to stamp out the inflation. It worked. It was painful, but effective. Inflation cooled and the economy returned to a more normal inflationary rate.
On the other hand, when the economy is slowing and needs a jolt, low interest rates are the medicine. What does this do? It rewards borrowers and punishes savers.
Let’s revisit the home remodel project. If rates go from 4% to 2% on your savings account and lending rates go from 8% to 6% your thought process likely is something along the lines of, “Well, I’m not making much in my savings and I can borrow the remaining portion of the funds for the remodel project at a low interest rate, so let’s go ahead with the project and maybe even spend a little more since the interest term are so favorable.” The home improvement store benefits from the increased sales, the labor you hire for the job now has more money to spend within the economy and the economic conditions improve.
We saw this at the onset of COVID in March of 2020. We were all locked in our homes and the amount of money being spent within the economy came to a grinding halt. The legislative government (President & Congress) responded by pouring money into the economy and the Fed responded by cutting interest rates to about as low as possible. It was a great time to borrow money at low rates, and a really lousy time to have a sizable balance in a savings account.
That response ended up being a little overkill, the benefit of hindsight, which is what led to the 2022 inflation problem.
Economic policy is designed to straddle rates being too low, which stimulates the economy, and rates being too high, which slows the economy. The Fed wants to have room on both sides of the coin to be able to adjust based on economic conditions.
Today we find ourselves in a reasonably good economic period … the stock market is hanging around all-time highs, inflation is reasonably tame, and the unemployment rate is quite healthy. So, the Fed is in a wait & see stage regarding its next move. The Trump administration’s tariff policies are a wild card that the Fed is monitoring very closely. Generally speaking, such policies are inflationary in nature, but inflation has been reasonably tame. If inflation starts kicking in the Fed will increase rates to reduce inflation, however if inflation stays moderated the Fed is likely to lower rates.
Now, there is more to interest rates than simply what the Federal Reserve sets the rates at, but the Fed is the starting point of understanding how the interest rate environment operates. For the sake of time, I’ll refrain from diving in deeper to this already complicated topic … I know you are relieved 😉
I fully understand this is super nerdy stuff, but since everything in the economy is tied to interest rates, I thought it might be worth a few minutes this fine Monday morning. 😊
These days mortgage rates are roughly 6.75% for 30-year term and 6.00% for a 15-year term … we are glad to provide insight into refinancing opportunities (not something we do directly, but glad to provide insights and referrals). As a general rule refinancing is only beneficial if the interest rate is at least 1% or more lower than your current rate.
Currently CD rates are around 4% and fixed annuity rates are around 5.5%, so if you have elevated levels of cash in your bank account feel free to reach out to us regarding taking advantage of these opportunities.
As always, if there is anything we can do to partner with you at a greater level, please just say the word. It brings my team and I tremendous joy to see our clients thrive. 😊
Make it a great week ahead.