Interest rate

An interest rate is the price of borrowing money, expressed as a percentage per year. If you borrow $100 at 5% interest, you owe $105 in a year. Interest rates are the single most important price in an economy — they determine how much it costs to borrow for a home, a car, a business expansion, or running a government. They are set by central banks at the short end and by markets at the long end, and they ripple through the value of every asset from bonds to stocks to real estate.

The mechanics: nominal vs. real

An interest rate is nominally a simple concept: the percentage of borrowed money you must pay back as interest annually. Borrow $1,000 at 5%, pay back $1,050 after one year.

But this is the nominal rate — the number quoted in contracts. More useful is the real rate — the nominal rate minus the expected inflation rate. If you borrow at 5% nominal and expect 2% inflation, your real rate is 3%. You are paying back 3% in purchasing power terms.

This distinction is crucial. A 5% rate sounds the same whether inflation is 0% or 4%, but the real burden is very different. And because lenders care about real returns — the purchasing power of what they get back — they set nominal rates based on their inflation expectations. High expected inflation drives nominal rates up; low expected inflation drives them down.

The yield curve: short rates vs. long rates

The Federal Reserve directly controls the federal funds rate, the rate at which banks lend reserves to each other overnight. In 2024, the Fed might set this at 4.5%. This rate ripples through the financial system: it influences the prime lending rate (what banks charge their best customers), mortgage rates, credit card rates, and the yield on short-term Treasury bonds.

But the Fed cannot directly control long-term rates. The yield on a 10-year Treasury bond is set by the market — the supply and demand for borrowing and lending over a 10-year horizon. The yield on a 30-year Treasury is also market-determined.

The yield curve is a graph of interest rates at different maturities. In normal times, the curve slopes upward: 2-year rates are lower than 10-year rates, which are lower than 30-year rates. This makes sense: lenders want compensation for committing capital for longer periods (the uncertainty of what inflation will be, what else could happen).

Sometimes, particularly when the Federal Reserve has raised short rates aggressively, the curve inverts — short-term rates exceed long-term rates. An inverted curve is often a recession signal, because it reflects a market belief that short rates will fall in the future when the economy weakens.

How interest rates affect asset values

Interest rates are a discount rate — the rate at which future cash flows are valued in today’s dollars. The higher the interest rate, the lower the present value of future cash flows.

This affects bonds directly. A bond paying $50 per year for 10 years is worth less when discount rates rise. If rates rise from 3% to 5%, that bond’s price falls, because investors can now buy new bonds paying 5%. Why own an old bond paying 3%?

For stocks, the effect is indirect but powerful. The value of a stock is theoretically the present value of its future earnings. When interest rates rise, the discount rate rises, and stock prices fall. Moreover, higher rates slow economic growth, which slows earnings growth. It is a double hit.

Real estate works the same way. The price of a house depends on mortgage rates. When mortgage rates rise from 3% to 6%, the monthly payment on the same house doubles, so fewer buyers can afford it, and prices fall.

The real rate and the natural rate

Economists talk about the natural rate of interest — roughly, the real interest rate consistent with full employment and stable inflation. In the US, estimates of the natural rate typically range from 0.5% to 2%. It is the rate the Federal Reserve is aiming for in the very long run.

In the short run, the Fed deliberately pushes rates above or below this natural rate. If unemployment is high, the Fed lowers rates below the natural rate, stimulating borrowing and spending, pulling the economy toward full employment. If inflation is high, the Fed raises rates above the natural rate, slowing the economy to bring inflation back down.

The art of central banking is choosing when to move above or below, by how much, and for how long.

Negative rates: when the central bank goes radical

In extreme crises or persistently weak growth, some central banks (the ECB in Europe, the Bank of Japan) have experimented with negative rates — charging banks to hold reserves rather than paying them interest. The idea is to penalize hoarding cash, encouraging banks to lend and spend.

Negative rates are controversial. They are hard to implement across the broader economy (cash cannot be charged negative rates), they can distort markets, and their effectiveness is unclear. The US Federal Reserve has not implemented negative rates, and most observers do not expect it to without a catastrophic economic contraction.

Interest rates and the Federal Reserve

The Federal Reserve’s primary tool is the federal funds rate. In normal times, the Fed targets a range (say, 4.5%–4.75%) and conducts open-market operations to keep the actual rate near that target. It does this by buying and selling short-term securities.

When the economy slows, the Fed cuts rates, lowering the federal funds target. When inflation rises, the Fed raises rates. The Fed is not omniscient; it gets the timing and magnitude wrong regularly. In 2021–2022, the Fed was slow to raise rates in response to inflation, and when it finally did, the magnitude of tightening was sharp.

Real-world complications: spreads and credit

The federal funds rate is a special rate — it is the cost for banks to borrow from each other. Consumer loan rates, mortgage rates, and bond yields are higher, because there is credit risk — the risk that the borrower defaults.

The difference is the spread. A mortgage might be federal funds plus 2.5 percentage points. A bond from a risky company might be 6% when Treasury rates are 4% — a 2% spread.

In good times, spreads are tight. In crises, spreads widen as investors demand more compensation for risk. During the 2008 financial crisis, spreads on corporate bonds blew out to 5–10 percentage points. This is why crises are so disruptive: not only do absolute rates matter, but credit risk premia rise sharply, making all borrowing more expensive.

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