A Guide to Why Interest Rates Matter

The Role of Interest Rates in Financial Markets
Interest rates play a crucial role in financial markets, influencing everything from consumer spending to business investment and stock market performance. They represent the cost of borrowing money and are a fundamental tool for central banks. A central bank, like the Federal Reserve in the United States, is a national financial institution responsible for overseeing the monetary system and policy of a country or group of countries.  Central banks manage economic stability by adjusting interest rates, which can speed up or slow down economic activity. When money is cheap, it stimulates borrowing, spending, and investments. Conversely, when money is expensive, it discourages these activities.

Impact on Personal Finances
We are most familiar with interest rates on mortgages, credit cards, personal loans, and savings accounts. The interplay between these rates profoundly affects our financial behaviors. For example, a low interest rate may entice someone to buy a home or vehicle, whereas a high interest rate on a bank account might encourage more savings. The same is true for small businesses or corporations. Low interest rates make it easier to purchase new buildings or equipment, while higher interest rates make these investments tougher. By manipulating interest rates, a central bank reaches into the heart of the economy and pulls on these levers.

How Central Banks Control Interest Rates
How does a central bank like the Federal Reserve control the interest rates in an economy? They do so through the Federal Funds Rate, which is the rate that commercial banks charge each other to borrow money overnight. The Fed can alter this rate by buying or selling short-term securities, making it more or less attractive for banks to keep money in their reserves instead of lending it out. This, in effect, controls how much money is flowing through the economy. When money is scarce, the cost to borrow it is high. When money is abundant, the cost to borrow it is low.   

Effects on Stocks and Bonds
Interest rates also impact on stocks and bonds. High interest rates increase the cost of capital and competition for it. When rates are high, businesses are less likely to invest in projects that will grow their earnings, and fixed-income alternatives may begin to look more attractive by comparison. The opposite is true when rates are low. It’s also important to know that bond prices are influenced by interest rates. When interest rates rise, bond prices fall. When interest rates fall, bond prices rise. Investors should be aware of these dynamics as they manage their portfolios.
 

This article was featured in the Fall 2024 edition of the Rising Dividend Report.

Read more articles from this issue here.