Short-term interest rates determine the costs that banks charge one another to borrow money. As a result, these interest rates play a major role in overall economic activity. The Federal Reserve tries to guide the direction of short-term interest rates in two main ways.
When the economy is growing rapidly. This typically means consumers are spending, companies are thriving and employment rates are high. In these circumstances, the Federal Reserve tends to raise short-term interest rates in order to prevent the economy from growing too quickly and risking inflation. Inflation is a general rise in prices, which may stem from an imbalance between the available money and the goods and services it can buy.
How does this affect you? Higher interest rates mean banks are willing to pay more interest on their deposit accounts, but this also means that the cost of borrowing will likely be greater.
When the economy is slowing. This generally means companies are less profitable, unemployment is rising and consumers are reining in their spending. In these circumstances, the Federal Reserve tends to lower short-term interest rates because it makes borrowing money less expensive. This rate drop enables businesses and consumers to afford various products and services, which in turn helps stimulate economic growth and avoid recession. A recession occurs when consumers hang onto their cash rather than spending it on the goods and services that keep the economy going.
How does this affect you? Lower interest rates mean money is more plentiful in the economy and banks are not as willing to pay a high return on your deposit. However, this also means that the cost of borrowing will likely be lower.
But that’s not all. The Fed is not the sole arbiter of interest rates. They can be affected by other factors as well. For instance, natural disasters and geopolitical events — such as the earthquake and tsunami in Japan, and the political unrest in the Middle East — that influence the world economy may also impact interest rates.