My colleagues Matt Tucker, Rick Rieder and Jeffrey Rosenberg have all discussed, at one time or another, how the actions of U.S. central bank leaders (i.e. “The Fed”) will affect interest rates. It is a topic that we follow very closely on The Blog. Today, I’m going to explain why.
Defining “interest rates”
For the millennials who have student loans, or for anyone with a credit card, it’s a term you’ve seen before: interest rates. It sounds a bit ominous, and the larger the percentage, the more nervous you’re likely to become. That’s because an interest rate determines the amount you pay the lender (or credit card company) to borrow the money loaned to you. So if you borrowed $10,000 for school at a 5% interest rate for a term of 120 months, you will have shelled out $12,728 to pay back your loan at the end of that 10-year period. The interest rate is essentially the cost of doing business with the bank.
From your wallet to your portfolio
We can apply this definition to the broader economic conversation, focusing on the aforementioned Fed. (Matt Tucker covers how the Fed dictates monetary policy in great detail here.)
As we saw in the months following The Great Recession, when economic growth slowed abruptly, the Fed moved to jumpstart the economy by lowering its target for the federal funds rate. The federal funds rate is the interest rate that large, institutional banks charge each other for overnight loans. A lower rate encourages borrowing. If banks are able to borrow at a lower rate, they’re more likely to lend to small businesses and consumers, spurring growth.
This is good news if you are looking to pay down debt or buy a car or a home during this period of record-low rates. This is bad news if you had cash in a savings account, as you earned next-to-nothing in interest.