What Do Interest Rates Mean, Anyway?

     I don't know if you even noticed, but a few days ago the entire financial world was on tenterhooks, wondering whether or not Janet Yellen and the Federal Reserve would dare (gasp!) to raise interest rates by ... get this, a whole 1/4 of a point.

     Frankly, I don't know what the big deal is. I remember interest rates at 12 and 15 percent in the early 1980s. So a quarter point, to me, seems negligible. Besides, I don't really care if I get the current 0.1 percent interest on my CD, or whether I get 0.35 percent interest. Either way, all I'll be able to buy with my interest is a pack of gum, or 1/4 of a gallon of gasoline.

     So I turned to my friend Jeremy Kisner, Senior Wealth Adviser at Surevest Wealth Management in Phoenix, to do some explaining for us. Here's what he says:

Jeremy Kisner

     Whether you prefer higher interest rates or lower rates depends on whether you are a saver or a borrower. The last time the Federal Reserve raised interest rates was June 2006. The Fed started cutting rates when the economy began deteriorating in late 2007, and it eventually cut rates to zero in December 2008. We are likely to see the first increase since the Great Recession by the end of this year

      Raising the Federal Funds rate is controversial. This is the only interest rate that the Fed directly controls. It is the rate that banks charge each other for overnight loans, and it primarily affects money market and savings accounts. The rate for mortgages is largely determined by the supply and demand for bonds, which the Fed does not directly control. A large group of economists think it is a terrible idea to raise the Fed Funds rate at this time. Others feel it is long overdue.

     Let’s try to understand why.

     The U.S. government has two ways to try to stimulate the economy: Fiscal Policy (government spending) and Monetary Policy (interest rates and money supply). The Federal Reserve is only responsible for monetary policy. The Fed’s two overarching goals are:

     1) Promote maximum employment, and

     2) Keep inflation as close to 2% as possible.

     Maximum employment and low inflation tend to be conflicting goals, which makes the Fed’s job a balancing act. Maximum employment (i.e., low unemployment) is usually only achieved when there is strong demand in the economy. Strong demand for products and services is good for employment but bad for inflation (pushes prices up). The Fed lowers interest rates when the economy is slow in order to stimulate the economy. On the other hand, it will raise interest rates if the economy is overheating and inflation is above its 2% target. You can see how it is difficult for the Fed to please everyone.

     Many people complain that it doesn’t even pay to keep your money in the bank at today’s interest rates. That was the Fed’s whole idea. It was trying to get you to take your savings out of the bank and go invest it in things that create jobs (e.g., new property, a factory, or equipment). The low interest rates of the past seven years have been good for young people who tend to be borrowers and job creators. The low rates tend to penalize seniors who are counting on interest from their savings accounts to supplement their retirement incomes.

     Zero interest rates have helped the U.S. economy recover from the great recession. The recovery has not been as quick or as robust as many would have liked. However, there's no question that the economy is bigger and stronger on almost every measure than it was before the 2008-09 recession.

     The question is why raise rates now? The economy is not in danger of overheating, and inflation is below the 2% target (largely due to the decline in energy costs). There are several reasons but the main ones are:

     1)  0% is an extreme measure, and the Fed likes to have some ammunition in case of a future downturn or economic shock. When rates are already at zero, it has very few tools left.

     2)  Historically, low rates can create asset bubbles. In other words, people start investing in things that don’t make sense. (Has anyone checked real estate prices in Silicon Valley or New York City?)

     How will a rate increase affect the economy and the stock market? Short-term, there is some volatility, but in the medium to longer term, an increase from 0 to .25% should be a non-issue. The Fed just wants to get off of zero. It is unlikely there will be any steep increases from there unless inflation makes a significant comeback.