|Market Insights in Two Minutes – These days you can’t escape discussions about “The Fed” or “rising interest rates.” In plain English, what is really happening?|
When people say that the “Fed is raising interest rates,” they are referring to the Federal Reserve increasing the interest rate that banks charge one another for overnight loans. The law states that banks must have a certain amount of cash reserves at a Federal Reserve bank. This “reserve requirement” is to ensure banks have sufficient money to satisfy deposit withdrawals. Banks that exceed their reserve requirement can lend to other banks overnight that don’t have enough.
As it becomes more expensive for banks to borrow money overnight, higher borrowing costs are passed on to their customers – things like mortgage and credit card rates tend to go up in response.
A higher Fed Funds Rate is meant to increase the cost of borrowing across the entire economy, often to slow growth and control inflation…this is precisely what is happening today. Making it more expensive to borrow money means, on the margin, fewer people will engage in debt financed consumption, and companies will be less likely to finance that next capital project.
Bonus: Bonds 101
So, if interest rates are going up, why are the value of my bonds going down? Let’s assume a bond with a maturity of 10 years that pays 3% interest. If rates rise and an investor can now purchase a newly issued 10-year bond that yields 4%, it stands to reason that the 3% yielding bond would be less valuable in the market – its price must fall to compensate for its inferior interest rate. One can simply hold that 3% bond until maturity, but the current value of a bond is determined by its relative attractiveness in the bond market at any given time.
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