By Mike Walden
We have a love-hate relationship with interest rates, especially in terms of their level. Investors in interest-paying investments like CDs (certificates of deposit), bonds and money market funds love higher interest rates because it means they earn more money. In contrast, borrowers dislike higher interest rates because they result in higher loan payments to buy homes, vehicles and other big-ticket items.
But there’s more to interest rates than just what they mean for our earnings or payments. Embedded in interest rates and their changes is information about various elements of the economy.
First, what is an interest rate? Essentially, an interest rate is the price of moving money over time. Consider this simple example. Say you need to borrow $1,000 for use today, and you agree to pay it back in one year. The interest rate is 6%. This means you can have $1,000 today if you agree to pay the lender $1,060 ($1000 x 1.06) a year later. Or, looking at the same example from the lender’s perspective, the lender considers not having $1,000 today but having $1,060 a year from now to be equivalent.
There are two components to any interest rate: the expected annual inflation rate and the real rate. The expected annual inflation rate compensates the lender for the loss in purchasing power of dollars between the time of the loan and the time of the loan repayment. Continuing with the above example, if the lender anticipates a 4% inflation rate between now and a year from now, then each dollar will be worth 4% less one year later. Hence, just to keep the purchasing power of dollars the same, the lender would need to charge a 4% interest rate.
Using economics lingo, the real rate reflects the “rate of time preference” of the lender. Translated to everyday language, the real rate is the rate of interest it will take for the lender to give up a dollar today after the lender has been compensated for expected inflation. Another way to think of the real rate is to assume there is no inflation, and then ask what someone would have to receive next year to give up using a dollar today. If the answer is 2%, then in the absence of inflation, a lender considers having $1 today or $1.02 a year later to be equivalent.
Any interest rate is the sum of the expected annual inflation rate over the life of the loan and the real rate. Using the example, with an expected annual inflation rate of 4% and a real rate of 2%, the observed interest rate is 6%.
There is a distinctive pattern to interest rates based on the length of the loan. Normally, the interest rate charged for longer loans will be higher than the rate for shorter loans. Why? Because forecasting inflation and factors that impact the real rate component – which I discuss later – are more difficult to do over a longer period of time than a shorter one. So normally, we observe an “upward sloping yield curve” – where interest rates rise with the length of the loan.
If the opposite occurs, meaning short-term interest rates are higher than long-term interest rates, then an “inverted yield curve” exists. This can happen if investors become worried about the current economy, and they consequently move money to longer-term investments. One of the worries could be an imminent recession. Interestingly, an inverted yield curve currently exists.
What can move interest rates up and down, and why? Obviously, the expected annual inflation rate can. Often, if the inflation rate has been rising, people can expect the rate to be higher in the future, and, thus, the inflation component of the interest rate will jump. This influence is usually confirmed when the Federal Reserve raises its interest rates.
Conversely, if the inflation rate is falling and is expected to continue to fall, then the inflation rate component should ultimately decline. Yet, again, often, the lower expected inflation rate will need to be supported by the Federal Reserve lowering its interest rate.
There is a special place in our economy for one interest rate. It is the interest rate paid on 10-year Treasury notes. A 10-year Treasury note is an investment with the federal government where the investor receives a fixed interest rate on the money invested, and the investment lasts for ten years. However, there is a market for buying and selling federal investments, so owners of 10-year Treasury notes can always sell prior to the ten years.
Many readers will be surprised to learn that investments with the federal government are considered safe. Despite many battles over the federal budget, the U.S. government has never missed an interest payment on Treasury investments.
There are two reasons 10-year Treasury notes receive attention. First is because interest rates on other loans – in particular, mortgage interest rates – closely follow the 10-year note rate up and down. So, if the 10-year Treasury note jumps, mortgage rates will follow.
The second reason for attention is what movement in the 10-year Treasury rate can tell us about the “real rate component” of interest rates. If the 10-year rate rises, usually that is interpreted as bad news about the economy. Conversely, if it drops, it means good news.
Recently, the 10-year rate has taken a big jump, putting it at almost a 20-year high. Many factors have been offered as reasons, including worries the Federal Reserve will keep interest rates higher than previously thought, concerns over federal borrowing and the national debt, and what the emerging Mideast war will do to prospects for wider fighting and impacts on oil prices.
There’s more to interest rates than meets the eye. Hopefully, with the background presented here, you can better decide why interest rates change and what they mean about the economy.
Walden is a William Neal Reynolds Distinguished Professor Emeritus at North Carolina State University.
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