Why are interest rates so important? We’ll try to lay out some of the reasons below:
- Interest rates dictate the consumer’s borrowing costs– whether you are buying a home, new car or taking out a school loan, most large purchases are financed. The lower the interest rate, the smaller your monthly payment will be. Lower payments allows consumers to spend more on goods and services since less of their monthly income is tied to debt service.
- Interest rates impact the government’s deficit– as rates rise, the government has to issue bonds at those higher rates. Debt service becomes a larger component of the deficit, causing the government to have to spend more of the budget on interest costs.
- Interest rates impact capital flows– higher interest rates will often attract foreign capital because of the prospects for higher returns. We have seen this recently, with emerging market investments cooling off, as many investors seem to be concerned that capital will flow from those countries back to the US, as rising interest rates in the US offer a compelling alternative for their capital.
As you can see, interest rates have a tremendous impact on our overall economy, often times in ways we can’t even imagine. As borrowers the last several years of declining rates have been a welcome sign, as we can finance our debts at lower costs. As savers, lower rates have created problems since we’ve had to take on more risk to get higher yields. We don’t know what direction interest rates are heading, but we know that it will be closely followed due to their importance on the overall economy and financial markets.