Interest rates: Two words that we are all familiar with, although few people really understand the reasons behind the numbers. Yet interest rates affect almost every aspect of our financial life – credit and store cards, the money earned on a bank account, buying and selling a car or house. The entire economy of the country is affected in some way, by the interest rate. Simply put, the interest rate is the amount of money it will cost you – or a bank - to borrow a certain amount of money from another bank or money lender. Interest rates are notoriously difficult to forecast and there are several reasons as to why they can change.
The job of monitoring the economy and adjusting the key interest rate if necessary belongs to the Federal Reserve Bank. Currently the influential position of Chairman of the Federal Reserve Bank is held by Alan Greenspan. He is in charge of a department of about a dozen economists which meets at least 8 times a year to decide if, when and by how much to raise interest rates. The basic reason why the interest rate might be raised – or lowered - is generally to boost the overall economy, and allow for long term growth and prosperity. By raising the interest rate even slightly, banks and other financial institutions are charged more to borrow money from each other. This increase in cost is passed onto the consumer – it will cost slightly more to take out a mortgage or a home equity loan. Even credit card and smaller loans will pass the increased cost to the consumer. The end result is that more money is being spent and earned.
In 2004 the interest rate was raised five times, the last increase of the year being about 10 days before Christmas. The current financial trend is for interest rates to rise gradually over the foreseeable future. As of the end of 2004, the prime rate of interest was 2.25%, the most recent increase being one quarter of a point. It may not sound like much, but multiplied many times over, it means a huge boost for the economy.
Basic supply and demand for available money is also one of the biggest factors affecting interest rates. To use the mortgage market as an example, if more and more people are buying and financing houses, more money is being borrowed, which means that lenders can charge higher rates to borrow the money. Similarly, in a slow economy, less people are borrowing money, the rates tend to be lower to attract customers, and there is a surplus of money to lend. Most people are conscious of interest rates when taking out a mortgage - a percentage of a point increase in the interest rate on your mortgage can amount to an extra payment of several hundred dollars over a year.
Inflation, which is defined as the general average change in the level of prices, also has an effect on interest rates. If inflation is high – or set to rise – investors will need a higher interest rate to consider lending money for more than the shortest term. The level of employment can also have an effect on interest rates – little unemployment means a strong and financially sound economy.
The government’s monetary policy can also have a significant effect on interest rates. Simply put, it is possible for the central bank to ‘create’ more money by just printing more of it. This makes interest rates lower, as more money is easily available to both people lending money, and borrowing it. If less money is printed, this can ‘tighten’ monetary policy and cause interest rates to rise. The government deliberately tries to ‘manage’ the amount of money in circulation and therefore the overall economy – a difficult thing to predict at best.
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