In order to invest your money in the right instruments, it is important to understand what rate your investments will grow at. Financial institutions offer interest rates based on numerous factors. Knowing about how interest rates are fixed can help you in making sound investments and in estimating the returns that you will get by investing in a particular instrument.
The impact of falling interest rates is that it is less costly to get credit. However, the returns on your savings would also be lower. Similarly, if interest rate increases, then loans become costlier, but you earn more on your savings.
Maintaining economic stability is the job of the Federal Reserve, which makes adjustments by increasing or decreasing short-term interest rates depending on the economic conditions. If the economy is good, then corporate profits will be high, money circulation will be more and unemployment will be lower. In such a situation, interest rates are usually increased to prevent overheating of the economy and to keep inflation in check.
Inflation occurs when there is a lot of money in the system, but goods and services are limited. Prices go up because of higher demand and restricted supply. Higher interest rates check the circulation of money so that prices do not rise sharply.
On the other hand, if the economy is not doing well and is slowing down, like we saw in the last two years, then interest rates are lowered. This helps in dealing with recession and in keeping the prices of goods and services stable so that running a business remains profitable. With lower interest rates, spending power is increased and people are encouraged to buy. This helps in preventing unemployment and economic stagnation that can happen if people are unwilling to spend.
The Fed rate is the most important factor that affects interest rates. If short-term interest rates are lowered or increased, then the costs of inter-borrowing between banks changes accordingly. This is reflected in the interest rates charged by banks from their customers.
However, various other economic factors also have an impact on interest rates. Short-term interest rates are the first to get affected by these factors, while long-term interest rates, like those charged on a mortgage, catch up with the changes slowly and they are determined by the long term outlook of the economy. That is why there is always more certainty about the returns from your investments if you invest for a longer time frame.