All Terrain Thinking

A Compendium of things I think are Important

Economics: It's not just whats' in your wallet

There are many interest rates

When we talk about interest rates, we seldom talk about specific rates, although what you care about are the specific rates. You care about the rates on your student loan, car loan, credit cards, and bank account, while policy makers may care about what the government pays on it's borrowing. There are a few rates that you may want to know a little bit about as you sort through the financial press, rates that we will talk about later.  The rates listed below would be included on the short-list of important rates.

• Discount rate: rate that the FED charges banks for overnight borrowing
• Federal funds rate: rate banks charge other banks for overnight borrowing
• Prime rate: the rate banks charge their 'best' customers
• T-bill rate: the rate on short-term (<1 year) on government (Treasury) securities
• Mortgage rate: the rate on home loans

The first two are always mentioned when you hear discussions of the Fed's monetary policies.  The discount rate is the rate that the Fed charges banks to borrow money overnight, while the federal funds rate is the rate on an overnight bank loan between banks.  These are the rates that that the Fed raised lowered in the early 1990s to help get the economy out a recession; raised in the mid 1990s to slow down an economy that many perceived as overheated and on the verge of renewed inflation; and lowered in the late 1990s to help keep the US economy from falling into a recession caused by the Asian crises. 

The second two are good measures of the cost of funds - how much the private sector's best customers must pay for money and how much the government pays for short-term debt.  In the case of the government, when it runs a deficit it must borrow money which it does by issuing bonds and securities (government IOUs).   It is the interest rate on these bonds that we looked up on the pages of the Wall Street Journal. 

The final rate is just one of an array of consumer / household related interest rates.  Others would be the rate on car loans and credit cards.  The mortgage rate is often times looked at as an influence on the housing industry.  When this rate rises it is often accompanied by stories that describe the chilling effect it will have on new home construction (housing starts) and home sales.  As you saw in one of the earlier examples where we used the on-line financial calculators, when interest rates rise, the monthly payments increase which should lower demand for the mortgages.  When the interest rate rises some individuals will simply drop out of the market unable to afford the higher payments. 

How do you reconcile the facts that in economics courses we talk about an interest rate while in the financial press we can find information on many interest rates? Economists can ignore the distinction between interest rates in our discussions of rates because they expect all rates will move together, although the fit is not a perfect one. When we talk about interest rates rising in our class discussions, you should expect the rates on loans, credit cards, home mortgages and bank accounts to all be rising.  This is why you will note that the last three rates in the above list often get mentioned at the time that the Fed changes the discount or federal funds rate - that any Fed policy is assumed to have a ripple effect on all rates, which is precisely the reason that we do not focus on individual rates.   

The relationship between various interest rates is evident in the graph below where you see that interest rates on three types of loans: loans to local governments (municipals), loans to low risk corporations (AAA), and loans to the federal government (GS). The rates on all three loans generally rose until the early 1980s at which time they began a general decline.  It is easy to see in this diagram that when we talk about an increase in interest rates, the increase can be seen in all o the individual rates. 

Now that we know that interest rates are prices and that we have a large number of rates, it is time to make an effort to explain some of the differences in rates.

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