The Federal Reserve will currently loan to banks for the low low rate or 0.25%. This is known as the Federal Funds Rate and the Fed decides what this rate will be based on the state of the economy. With a rate that is as close to zero as it will ever get, the message the Fed is sending sounds something like: “holy crap the market is a pile of dung we have to get this poo moving again!” As you can see the Fed has a fascination with manure (probably of the bull variety).

Low interest rates encourage borrowing by businesses and people. This is why you can get a mortgage for less than 5% if you’ve got good credit. If you’re thinking of buying a house, there has never been a better time to lock in a fixed rate. Low interest rates don’t just encourage borrowing, but it discourages savings. Even the online savings banks are offering crappy interest rates these days. If you find something over 2% it’s cause for celebration. Since our savings accounts aren’t offering much return, we don’t see much reason to save. Now many of us do still save, but that is a circumstance of the recession or personal choice. On aggregate, low interest rates discourage saving.

On the other end of the spectrum is higher interest rates. A few years ago some of us were racking in over 5% on our savings accounts. We call this, “the good ole days”. If you didn’t have any debt and were saving at this rate, things were good. The Fed will raise interest rates when they want to discourage borrowing and spending. They’ll do this to try and reign in the economy if they think it’s growing too fast. An economy that grows too fast is at risk of getting “bubbly” and having run-away inflation.

So low interest rates encourage overall economic growth and high interest rates do the opposite. Economic nerds will argue there’s more to it than that, which is true, but then again economic nerds over-complicate everything to justify their careers. We can look at current interest rates and see what issues the Fed considers the most urgent.

By keeping rates low for so long it’s obvious they’re doing what they can to stimulate the economy. This is called monetary policy (the contrast is fiscal policy which is what Congress and the president will do to control the economy by way of spending and tax policy). The Fed is concerned with keeping the economy out of recession and depression. It also tells us the Fed does not consider inflation to be an immediate issue. Many would say inflation could be a problem considering all the additional money the government and the Fed have injected into the economy. The Fed considers inflation a long-term issue that must be dealt with. It’s like worrying about getting that odd-looking mole removed after you’ve just been shot in the stomach. Let’s stop the bleeding first.

But of course I haven’t even told you when interest rates will go back up again. How rude of me. Even the almighty Ben Bernanke doesn’t know that one yet. They’ll slowly raise interest rates once they are confident that the economy is capable of growing on its own again. Once this happens inflation will start to become an issue (because we’ll be spending all the cash the government put into the economy). Many experts expect interest rates to start rising as early as summer-time. But these experts are only guessing. I wouldn’t be surprised to see a rate increase sometime this year. Perhaps the funds rate rising to 1% or 1.5%. But if the recent increases in GDP were only a fluke, we’ll have low interest rates for the rest of 2010.

So the real answer to when interest rates will go back up again is: when you start spending the money in your savings.

Photo: DCJohn

categories: economics, government, personal finance