How Interest Rates Work

Even the most casual of stock market observers must be aware of the pervasive influence the Federal Reserve Bank can and does have on stock price movement by virtue of its control of monetary policy. Although one of the tools of the Federal Reserve system is the ability to alter margin rates, the Fed has dropped this as a policy tool and works almost exclusively through its ability to influence interest rate movements.

As has also been widely reported, the Fed's deliberations on what policy initiatives to adopt are closely linked with the central bank's concerns about the prospects for inflationary pressures to rebuild in the economy. What is the relationship between interest rates and inflation and why does something that seems to be largely a capital market issue, matter to the stock market?

The answer lies firstly, in properly understanding what an interest rates is. Most people think of money as simply a medium of exchange that came into existence in ancient times as a means of facilitating trade. People used to barter merchandise to obtain their needs. This system became increasingly unwieldy and merchants and bankers banded together to create transferable certificates that represented available quantities of merchandise. This eventually turned into what we today refer to as money or currency.

But money itself is also a commodity. Although we generally think of money in terms of what we can purchase with it, the fact is that if we do not need it at present we can give it to someone else who may need it. If it is a friend of relative, we may not give compensation a second thought and expect to get back no more than we lent. However, in a business environment we may feel we are entitled to something of value in return.

If we were in the car rental business, we would impose a daily fee for the use of the car, plus extra charges for insurance, gasoline usage etc. Someone who is in the money business, in effect rents out money and expects some fee in return as well. This fee is what is called the interest rate.

Specifically, when renting a car, the agency charges a rate it believes covers all its costs and in addition provides a profit component. The renter is also required to buy insurance or have coverage from another dealer, to protect against damage.

When borrowing money, the borrower is also expected to pay a rate that will cover the lender for any possible damages or "wear and tear," plus some profit. In the vernacular, these components are referred to as the inflation premium and credit risk. The greater the threat of inflation and the more risk the lender accepts if the borrower has some history of not repaying promptly or fully, the higher the interest rate premium will have to be.

There is a rule of thumb in banking circles (although not universally accepted) that the "real cost of money" is about 3.0%, with anything above this rate representing the inflation and risk premiums.

The inflation premium is necessary to maintain the lenders purchasing power. If the rate of inflation is running at five percent a year, what is really happening is that the value of the money is depreciating at a rate of five percent a year. What cost $1.00 the first year, sells for $1.05 the following year.

When lending money, the lender in effect says I need to receive five cents on every dollar just to keep my purchasing power stable. Beyond this, he will want to earn a bit of a profit, which the "rule of thumb" estimates to be about 3.0%. Accordingly, if the long-term rate of inflation is perceived to be about 5.0%, then we would assume long-term rates to be in the vicinity of 8.0%.

Inflation is not a phenomenon that just bursts undetected on the scene one morning. It is usually the result of economic conditions that have been festering for a period of time, without being checked or countered. The Federal Reserve Board, mindful of the economic toll the prolonged period of double-digit inflation had on the U.S. economy in the 1970’s, has determined that preventing a repeat of this cycle is one of its primary responsibilities.

There are several ways that inflation comes into being. One is when a shortage exists in a desired product. The available supply may be rationed through price increases. Another method of inflation is provided by rising costs of the components of a product. When oil prices rise very rapidly, products or services that are very dependent on energy will command higher prices to compensate for this increased costs.

When fuel costs soar, airlines need to charge more for tickets to counter their much higher fuel bills. If labor is in short supply, workers may demand higher salaries to keep producing goods or providing services. These costs must be passed along to the consumer if the provider is to maintain a reasonable profit margin on his services. To the extent the consumer is forced to pay more for a product or service without obtaining any incremental benefits, the increase is inflationary.

If, however, the higher costs are offset by some improvement in the product then the cost increase may be warranted. If auto manufacturers raise prices for their vehicles by several hundred dollars the increase would be inflationary if there were no commensurate benefit in the new vehicles. However, if the manufacturer includes in the base price accessories that previously were charged for separately, the higher cost may not be deemed inflationary.

Historically, inflation was described as being caused either by "wage push" or "demand pull." With various international cartels in a position to artificially influence the costs of some raw materials, such as OPEC’s role in the oil market, there can be inflationary pressures that are outside the traditional channels.

The net effect of inflation on the consumer, is to rob him of purchasing power. There is always some inflation going on in a growing economy. When the increase is moderate, the consumer is usually able to offset the effect through wage increases. This generally allows him to keep pace and hopefully even keep a little bit ahead of the trend.

At other times, wages alone do not provide adequate relief and the consumer may have to find ways around this that can enable him to maintain a certain standard of living or consumption pattern. One method is through a simple process of substitution. In one form or another, everybody practices this on occasion. If one goes into a store for a Hershey chocolate bar and they are sold out, the Nestle bar may make an acceptable alternative. Similarly if the price of coffee were to spike higher, some consumers may elect to substitute another beverage such as tea. To the extent substitution is an alternative, the effect of inflation can be mitigated. If enough consumers are able to switch products, such activities may even be able to bring down the price of the particular product by leaving the producer with unsold merchandise.

However, such efforts to repel inflation or mute its impact, are not always successful or even feasible. To the extent that they are regarded as threatening to the economy, they may call for more drastic action. This could take the form of an organized boycott of a particular good or service if it was felt that this could bring about a price rollback.

If the threat of inflation is more widespread or runs the risk of causing more severe damage to the economy, the Federal Reserve Bank may find itself compelled to take action to thwart this prospect.

The Federal Reserve Bank is charged with managing the nation's monetary policy. In broad terms, this relates to controlling the amount of money in the economy and thereby granting it considerable influence in the setting of interest rates. In addition to the aforementioned impact inflation can have on interest rates, by raising the inflation premium; the Fed too can have an impact by increasing or decreasing the availability of money for lending purposes.

Working through the nation's banking system, the Federal Reserve controls the amount of reserves within the banking system, which in effect, affects the ability of the banking system to lend money. If money is readily available, it is seen as encouraging business to spend more on new products, acquisitions, raw materials and labor. This in turn is seen as encouraging some upward movement in prices to pay for these expenditures. As expectations increase throughout the economic system, everybody wants to share in what is perceived as the new found wealth. If at the same time the government seeks to participate in all this by spending beyond its means, namely raising the deficit, and the Fed acquiesces by monetizing the debt. This monetization may initially lower rates by making more money available. But before long the market will realize the seeds of another inflationary spiral are being sown and before long rates will be heading higher.

The Fed, therefore, has to walk a very tight line between making credit too available, and fostering inflation on the one hand, and being too stingy, and causing an economic slowdown, on the other.

There are several tools available to the Fed to manage the money supply and credit. The most common, used almost every business day, is the intervention by the Fed's operating arm, the Open Market Desk, in the money market. The desk enters the market almost every day to arrange Repo or Reverse Repo. In simple terms, this operation involved either the purchase or sale of debt by the Fed from or to its dealer network, on a temporary basis.

When it buys securities (arranges a repo), the Fed in effect provides the banking system with short-term money which increase its reserves, and allows its to lend more money or conversely borrow less. When it arranges reverse repo, or matched sale, is sells securities to the dealers forcing them to get more money to pay the Fed for securities, thereby draining reserves and firming interest rates.

The Fed also controls the levels of required reserves, pegs the discount window rate and determines how much margin investors are allowed for securities transactions. However, these are rarely altered and most are utilized mainly when the Fed desires to bring about a fundamental change in the economic outlook, not fine tune a well performing engine.

When we read in the paper that the Federal Reserve is expected to tighten monetary policy, or raise rates, at it next FOMC meeting, what is meant is that the central bankers have decided to provide less credit in the form of reserves to the banking system. This in turn drives up the price (interest rate) for Federal Funds, which are essentially excess reserves that banks trade among themselves.

Banks are required to maintain reserves on all their deposits. Every Wednesday they are required to balance their books and prove they have adequate reserves. Usually the large money center banks operate very efficiently and employ all their deposits to the fullest extent permissible. Sometimes they run over and are short reserves. At the same time smaller country banks almost always have excess reserves because they operate less efficiently or in markets that are less active. These banks can lend their excess reserves to the money center banks through the Federal Funds Market. The Fed's requirement is that the banking system as a whole be in reserve balance.

When the Fed operates to make less reserves available, it in effects constrains banks from lending. This in turn leads to higher interest rates as a means for rationing the available credit. The higher rates should cancel some borrowing plans, in effect slowing the economy enough to wring out some inflationary expectations. While this may sound like a bit of a "Catch-22" situation, it is rather a system of cause and effect with more expensive money, namely higher interest rates, serving to undercut growth efforts and visa versa.