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Show Why your interest rates rise and fall By CURTIS G. MARSH The ups and downs of interest rates mystify many of us. We don't really understand why one year we earn 9 percent on our CDs or money-market funds and the next year we get just six percent. In fact, there's no mystery about why interest rates rise and fall. They simply reflect inflation, the demand for credit, the pace of growth of the economy, the behavior of the dollar, and the monetary policy of our central bank, the Federal Reserve. To understand interest rates, you should focus first on inflation. infla-tion. The higher the inflation rate and the stronger the expectations expec-tations of future inflation the higher interest rates must be. Otherwise, people will not deposit their money in financial institutions, but will buy certain stocks, real estate or tangible assets, which hold their value well during inflationary periods. What investors are actually seeking when they demand higher interest rates is a comparable real rate of return to what they earned during times of price stability. Real return is the difference differ-ence between the interest rate and the inflation rate. Historically, Historical-ly, it has been two percent to three percent, but at times in the highly inflationary late 1970s and early 1980s, ii fell as low as minus five percent. That means people were actually losing money on their investments, even while earning double-digit interest. The main reason returns on bank deposits and money-market funds are so low right now around 7 percent is that inflation has been lower in a three percent to four percent range. So today's low rates are, in fact, giving investors historically high real returns of four percent or more. Another major force affecting interest rates is loan demand. Money is, in a sense, a commodity like any other. When demand for this commodity is strong or the supply is limited, its "price" the interest rate rises. Conversely, when demand is weak or supply is plentiful, rates fall. The demand for money is expressed as demand for loans. Business borrows to build plants and buy new equipment; government gov-ernment borrows to finance new or expanded spending programs; prog-rams; and households borrow to buy homes, cars and other expensive items. Loan demand is closely related to how fast the economy is growing. When economic growth is robust, business, government govern-ment and households tend to increase their spending and their borrowing. With more borrowers competing for loans, interest rates rise. The activity of the dollar also affects interest rates, such that a lower dollar can mean more inflation, which, in turn, causes higher interest rates, and vice-versa. Federal Reserve policy is another determinant of interest rates, but it primarily affects short-term rates (i.e., 90 days or less). By varying the amount of reserves it provides the banking system, the Fed controls the growth of the nation's money supply. By raising and lowering the interest rate it charges the banks for these reserves, it controls the Treasury bill rate and the federal funds rate. (The latter is the rate banks charge each other for overnight loans.) Understanding why interest rates rise and fall won't change how they operate, but it should help us to make more informed investment decisions. By keeping an eye on current economic indicators and the activity of the dollar, and by watching out for changes in Federal Reserve policy, we can better direct our investments so that they continue to work for us, not against us. |