We have been hearing about the coming change in policy by the Federal Reserve. It is commonly referred to as The Fed but its official name is The Board of Governors of the Federal Reserve System. Most people think that interest rates will rise as a result of the Fed’s meetings sometime early in 2014. We've seen some rates shoot up 1% very quickly since the chatter escalated last May but subsequently things settled down for a while. The Federal Reserve has been artificially keeps rates down by buying bonds on the open market. The more bonds that are purchased drives up the price of bonds and their respective yields lower. You may have heard the term quantitative easing, or QE, which refers to the Fed’s bond buying program. The question becomes why is the Federal Reserve so intent on keeping rates low?
The theory is that if interest rates are low people will be encouraged to borrow money and spend it. The banks will be encouraged to lend money to people who will spend it. The more people spend, the more the economy grows. The more the economy grows, the higher rates will go because otherwise inflation will spiral out of control. If inflation becomes too rampant, the value of currency will fall. If the value of your currency falls, foreigners won’t want it because it is losing value. Therefore we can see that there is a delicate balance between interest rates, inflation and currency values.
Some people just dismiss the relationship between these factors as the normal result of a cause and effect situation. Let’s use an example of inflation rising. Just because the rate of inflation rises doesn’t automatically mean that rates should suddenly increase. What if the rate of inflation increased due to temporary shortages of certain durable goods or raw materials? This might be a short-term spike which will correct itself over time and the effects should only be limited to the respective industry. If rates were to move up quickly, the entire economy would now be affected instead of limiting it to the particular industry. Sometimes having a lower valued currency encourages outside investment which is a good thing for the economy. Again, just because the currency value goes down doesn't automatically mean that inflation is out of control.
If all these factors are interrelated, it must mean that there is an ideal and delicate balance between interest rates, inflation and currency values. If you earn more on your savings, you’ll pay more to borrow. If you earn less on your savings, you’ll pay less to borrow. Lower rates generally mean lower inflation. Higher rates generally mean higher inflation. It would seem they cancel each other out; if you earn more and pay more and earn less but pay less, they balance each other out. Not so fast! When you borrow don’t you lock in rates for a period of time? If you obtain a 30-year mortgage and choose a fixed rate, your rate will stay the same for the 30-years. This means that the timing of spending or purchases is critical to the “effect” of interest rate changes. Wouldn’t there be a huge difference between locking in a mortgage at 8% versus 4%? Wouldn’t a 4% mortgage buy more house than an 8% mortgage?
People always have an answer or a counter-claim. You were probably just thinking that it would be easy just to refinance when rates went back down. What if rates didn’t go back down for a long period of time? You would think that it would be better to lock in rates for the long term when rates are really low. Rates have been very low for years now yet people are encouraged to lock in rates for 10 or 15 years instead of 30 years. Wouldn't it make more sense to lock in low rates for a longer period of time than a shorter one? Wouldn't it make more sense to lock in high rates for a shorter period of time than a longer one? Don't many people end up buying high and selling low? Why do so many people do the exact opposite of what makes the most common sense?
This brings us right back to the question of which is better, high interest rates or low interest rates? There is no one correct answer. The best scenario lies in the delicate balance in the relationship between interest rates, inflation and the value of money. There is no magic bullet to solve our economic problems. If everyone saved as much money as they could and only bought what was necessary to live, would the economy grow? Isn’t this what people in some countries do now? In our country Americans expect the economy to grow and therefore spend money. If the economy doesn’t grow, should the answer be to stop spending? If Americans stop spending money and start saving as much as they can, won’t the economy slow down even more? If people save more, the demand for borrowing would go down. If fewer people borrow the rates go down. This means that with more savings we might get lower rates again. Didn’t we just go full circle here? There’s your answer!