What Is Interest Rates?

Definition

Interest rates refer to the percentage at which borrowed money is paid back, with the added cost of borrowing, as first described by Eugen von Böhm-Bawerk in his work on capital and interest in 1884.

How It Works

The mechanism of interest rates is based on the principle of supply and demand in the money market, where lenders and borrowers interact to determine the price of borrowing. The Federal Reserve, the central bank of the United States, plays a crucial role in setting interest rates through its monetary policy decisions, such as the federal funds rate, which influences the prime lending rate and subsequently affects the entire economy. For instance, when the Federal Reserve lowers the federal funds rate, it becomes cheaper for banks to borrow money, which in turn allows them to lend more to consumers and businesses, stimulating economic growth, as seen in the 2008 financial crisis when the Federal Reserve lowered the federal funds rate to nearly zero.

The interest rate mechanism also involves the concept of opportunity cost, where lenders weigh the potential returns on alternative investments, such as bonds or stocks, against the returns on lending. This opportunity cost is reflected in the yield curve, which plots the interest rates of bonds with different maturities, providing a snapshot of the market's expectations for future interest rates. The yield curve is closely watched by investors and policymakers, as it can signal changes in the economy, such as a potential recession, as seen in the inverted yield curve of 2007, which preceded the 2008 financial crisis.

The transmission of interest rates to the broader economy occurs through various channels, including the bank lending channel, where changes in interest rates affect the amount of credit available to households and businesses, and the wealth effect, where changes in interest rates influence the value of assets, such as stocks and bonds, and subsequently affect consumer spending. For example, a decrease in interest rates can lead to an increase in stock prices, as seen in the stock market rally of 2019, when the Federal Reserve cut interest rates three times.

Key Components

• Nominal interest rate: the stated interest rate on a loan or investment, which does not account for inflation, and is typically set by central banks, such as the European Central Bank, which sets the main refinancing rate for the eurozone.
• Real interest rate: the nominal interest rate adjusted for inflation, which reflects the actual purchasing power of the borrowed money, and is closely watched by investors, as it affects the attractiveness of investments, such as U.S. Treasury bonds.
• Liquidity premium: the excess return demanded by lenders for holding a less liquid security, such as a long-term bond, which reflects the risk of not being able to sell the security quickly enough, as seen in the high-yield bond market.
• Term premium: the excess return demanded by lenders for holding a longer-term security, which reflects the risk of not being able to reinvest the principal at a similar interest rate, as seen in the mortgage-backed securities market.
• Credit risk premium: the excess return demanded by lenders for holding a security with a higher credit risk, such as a junk bond, which reflects the risk of default by the borrower.
• Inflation premium: the excess return demanded by lenders for holding a security with a higher inflation risk, which reflects the risk of erosion of the purchasing power of the borrowed money, as seen in the emerging markets.

Common Misconceptions

• Myth: Interest rates are only determined by central banks — Fact: Interest rates are also influenced by market forces, such as supply and demand in the money market, as seen in the Libor scandal.
• Myth: Higher interest rates always lead to higher economic growth — Fact: Higher interest rates can lead to higher borrowing costs, which can slow down economic growth, as seen in the 1981 recession.
• Myth: Lower interest rates always lead to higher inflation — Fact: Lower interest rates can lead to higher economic growth, which can lead to higher inflation, but this is not always the case, as seen in the Japanese economy, which has experienced low interest rates and low inflation for decades.
• Myth: Interest rates are the only factor that affects borrowing costs — Fact: Other factors, such as credit scores and loan-to-value ratios, also affect borrowing costs, as seen in the mortgage market.

In Practice

In 2019, the Federal Reserve cut interest rates three times, lowering the federal funds rate to a range of 1.5% to 1.75%, in an effort to stimulate economic growth and mitigate the risks of a recession. This decision had a significant impact on the economy, as it led to a decrease in borrowing costs for consumers and businesses, and subsequently boosted consumer spending and investment. For example, Apple was able to issue $7 billion in bonds with a yield of 2.5%, which is lower than the yield on similar bonds issued by the company in previous years. This decrease in borrowing costs allowed Apple to invest in new projects and expand its business, which in turn contributed to the growth of the U.S. economy.