Changes in interest rates can have both positive and negative effects on the U.S. markets. When the Federal Reserve Board (the Fed) changes the rate at which banks borrow money, this has a ripple effect across the entire economy. Below, we will examine how interest rates can have an effect on the economy as a whole, the stock and bond markets, inflation and recessions.

Tutorial: Economics Indicators To Know

How Interest Rates Affect Spending
With every loan, there is a possibility that the borrower will not repay the money. To compensate lenders for that risk, there must be a reward: interest. Interest is the amount of money that lenders earn when they make a loan that the borrower repays, and the interest rate is the percentage of the loan amount that the lender charges to lend money.

The existence of interest allows borrowers to spend money immediately, instead of waiting to save the money to make a purchase. The lower the interest rate, the more willing people are to borrow money to make big purchases, such as houses or cars. When consumers pay less in interest, this gives them more money to spend, which can create a ripple effect of increased spending throughout the economy. Businesses and farmers also benefit from lower interest rates, as it encourages them to make large equipment purchases due to the low cost of borrowing. This creates a situation where output and productivity increase. (Traders rejoice when the Fed drops the rate, but is it good news for all? Find out in How Do Interest Rate Cuts Affect Consumers?)

Conversely, higher interest rates mean that consumers don't have as much disposable income and must cut back on spending. When higher interest rates are coupled with increased lending standards, banks make fewer loans. This affects not only consumers, but also businesses and farmers, who cut back on spending for new equipment, thus slowing productivity or reducing the number of employees. The tighter lending standards mean that consumers will cut back on spending, and this will affect many businesses' bottom lines. This will cause the businesses to reduce the number of employees that they have and to hold off on any major equipment purchases. (For more information, read How Much Influence Does The Fed Have?)

The Effect of Interest Rates on Inflation and Recessions
Whenever interest rates are rising or falling, you commonly hear about the federal funds rate. This is the rate that banks use to lend each other money. It can change daily, and because this rate's movement affects all other loan rates, it is used as an indicator to show whether interest rates are rising or falling.

These changes can affect both inflation and recessions. Inflation refers to the rise in the price of goods and services over time. It is the result of a strong and healthy economy. However, if inflation is left unchecked, it can lead to a significant loss of purchasing power.

To help keep inflation manageable, the Fed watches inflation indicators such as the Consumer Price Index (CPI) and the Producer Price Index (PPI). When these indicators start to rise more than 2-3% a year, the Fed will raise the federal funds rate to keep the rising prices under control. Because higher interest rates mean higher borrowing costs, people will eventually start spending less. The demand for goods and services will then drop, which will cause inflation to fall. (Find out why economists are torn about how to calculate inflation in The Consumer Price Index Controversy.)

A good example of this occurred between 1981 and 1982. Inflation was at 14% a year and the Fed raised interest rates to 20%. This caused a severe recession, but it did put an end to the spiraling inflation that the country was seeing. Conversely, falling interest rates can cause recessions to end. When the Fed lowers the federal funds rate, borrowing money becomes cheaper; this entices people to start spending again.

A good example of this occurred from 2001 to 2002, when the Fed cut the federal funds rate to 1.25%. This greatly contributed to the economy's 2003 recovery. By raising and lowering the federal funds rate, the Fed can prevent runaway inflation and lessen the severity of recessions. (To learn more, read The Federal Reserve's Fight Against Recession and The Impact Of Recession On Businesses.)

How Interest Rates Affect the U.S. Stock and Bond Markets
Investors have a wide variety of investment options. When comparing the average dividend yield on a blue-chip stock to the interest rate on a certificate of deposit (CD) or the yield on a U.S. Treasury bond (T-bonds), investors will often choose the option that provides the highest rate of return. The current federal funds rate tends to determine how investors will invest their money, as the returns on both CDs and T-bonds are affected by this rate.

Rising or falling interest rates also affect consumer and business psychology. When interest rates are rising, both businesses and consumers will cut back on spending. This will cause earnings to fall and stock prices to drop. On the other hand, when interest rates have fallen significantly, consumers and businesses will increase spending, causing stock prices to rise.

Interest rates also affect bond prices. There is an inverse relationship between bond prices and interest rates, meaning that as interest rates rise, bond prices fall, and as interest rates fall, bond prices rise. The longer the maturity of the bond, the more it will fluctuate in relation to interest rates. (Learn the basic rules that govern how bonds are priced in Bond Market Pricing Conventions.)

One way that governments and businesses raise money is through the sale of bonds. As interest rates move up, the cost of borrowing becomes more expensive. This means that demand for lower-yield bonds will drop, causing their price to drop. As interest rates fall, it becomes easier to borrow money and many companies will issue new bonds to finance expansion. This will cause the demand for higher-yielding bonds to increase, forcing bond prices higher. Issuers of callable bonds may choose to refinance by calling their existing bonds so they can lock in a lower interest rate.

Interest rates affect the economy by influencing stock and bond interest rates, consumer and business spending, inflation, and recessions. However, it is important to understand that there is generally a 12-month lag in the economy, meaning that it will take at least 12 months for the effects of any increase or decrease in interest rates to be felt. By adjusting the federal funds rate, the Fed helps keep the economy in balance over the long term. Understanding the relationship between interest rates and the U.S. economy will allow us to understand the big picture and make better investment decisions. (For related reading, see How Interest Rates Affect The Stock Market, Trying To Predict Interest Rates and It's In Your Interest.)

Related Articles
  1. Investing Basics

    What Does Plain Vanilla Mean?

    Plain vanilla is a term used in investing to describe the most basic types of financial instruments.
  2. Investing Basics

    3 Key Signs Of A Market Top

    When stocks rise or fall, the financial fate of investors change, as well. There are certain signs that can reveal a stock’s course, and investors don’t need to be experts to spot them.
  3. Investing

    Have Commodities Bottomed?

    Commodity prices have been heading lower for more than four years, being the worst performing asset class of 2015 with more losses in cyclical commodities.
  4. Fundamental Analysis

    Emerging Markets: Analyzing Colombia's GDP

    With a backdrop of armed rebels and drug cartels, the journey for the Colombian economy has been anything but easy.
  5. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  6. Options & Futures

    Pick 401(k) Assets Like A Pro

    Professionals choose the options available to you in your plan, making your decisions easier.
  7. Investing

    Asset Manager Ethics: Rules Governing Capital Markets

    The integrity of the capital markets needs to be kept at utmost importance for all investors. This article shows how to maintain the integrity while investing.
  8. Fundamental Analysis

    Use Options Data To Predict Stock Market Direction

    Options market trading data can provide important insights about the direction of stocks and the overall market. Here’s how to track it.
  9. Economics

    Is the U.S. Economy Ready for Liftoff?

    The Fed continues to delay normalizing rates, citing inflation concerns and “global economic and financial developments” in explaining its rationale.
  10. Economics

    What's the 1913 Federal Reserve Act?

    The 1913 Federal Reserve Act was a pivotal congressional act that helped establish the Federal Reserve System as it exists today. It is one of the United States financial system’s most influential ...
  1. How does a bond's coupon rate affect its price?

    A bond's coupon rate has a large effect on its market price because it dictates the amount of income the bond generates per ... Read Full Answer >>
  2. Does the S&P 500 index include dividends?

    The S&P 500 index includes dividends. As of March 2015, the dividend yield for the S&P 500 was 1.91%. This is below ... Read Full Answer >>
  3. What growth rate does the financial services sector demonstrate on average?

    Growth in the financial services sector can be broadly divided into two periods: growth before 1980 and growth since 198 ... Read Full Answer >>
  4. What are the typical durations for a certificate of deposit?

    For investors and savers seeking principal protection on an investment, a certificate of deposit (CD) can be a smart addition ... Read Full Answer >>
  5. What are the pros and cons of owning an equity REIT versus a mortgage REIT?

    There are several different types of real estate investment trusts (REITs) including equity REITs, mortgage REITs and hybrid ... Read Full Answer >>
  6. Who decides to print money in Canada?

    In Canada, new money comes from two places: the Bank of Canada (BOC) and chartered banks such as the Toronto Dominion Bank ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  2. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  3. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  4. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  5. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  6. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!