It’s interesting to note that an entire generation has come of age during a time when interest rates have essentially been a positive factor for the economy. For the past decade, we have lived during a period of very low, almost zero interest rates. Even older generations, the oldest of which suffered under double-digit interest rates in the 70’s and 80’s, have grown accustomed to this low rate environment after a nearly three-decade decline in interest rates.

Only in the last couple of years, as the Federal Reserve Bank (the Fed) has begun to ratchet up short-term rates, have interest rates once again become a subject of conversation – largely because of the potential impact of higher interest rates on the economy. So, exactly how are interest rates determined and just how do they impact the economy?

There are essentially two forces that determine the direction of interest rates:

The Fed

The Fed plays a key role in determining the direction of interest rates because it sets the Fed funds rate which is the interest rate banks are charged to borrow from the Fed to meet their reserve requirements. While it can affect yields in short-term investments like savings accounts, it doesn’t have a material effect on long-term borrowing which is impacted more by the yields on Treasury bonds. However, the ripple effect of a Fed funds rate increase or decrease gradually works its way throughout the economy.

The Fed rate is a tool the Federal Reserve uses to increase or decrease the cost of money in the banking system. The reason for that is, when the economy heats up too much it increases the risk of inflation, which can hurt the economy. So, it increases the cost of money by raising the Fed funds rate to slow down borrowing and consumer spending. If it miscalculates and it slows the economy too much, it could send it into a recession. When that happens, the Fed will decrease the Fed funds rate to stimulate borrowing and consumption.

Investor demand for Treasury bonds

The interest rates charged on longer-term loans, such as mortgages, car loans, student loans, and installment loans, are not impacted by the Fed funds rate as much as they are the yields on 10- and 30-year Treasury bonds. Treasury bond yields are set when they are auctioned by the U.S. Treasury Department. Investor demand determines the yield. When demand for Treasury bonds is high, the yields can be low. When demand decreases, the yields are pushed higher to attract investors.

However, because Treasury bonds are bought and sold on the open market, their yields are in constant motion. Because Treasury bonds are considered a safe haven, investor demand increases when the economy or the stock market sours. When that happens, their prices increase which pushes their yields down. Conversely, when demand decreases, typically when the stock market is performing well, their prices decrease which drives their yield higher.

Generally, longer-term debt instruments like mortgages, take their cue from Treasury bonds. Until recently, Treasury bond yields have been at historical lows, which is why mortgage rates were also at their historical lows. More recently, Treasury yields have been increasing and mortgage rates have followed.

The Effect of Higher Interest Rates on the Economy

In an effort to stimulate the economy following the financial crisis and Great Recession, the Fed lowered interest rates to near zero over the following seven years and Treasury yields (and by correlation longer-term debt instruments) also fell to historically low levels. In response to the surge in economic growth in recent years, the Fed has begun to raise the short-term rate and Treasury yields have begun to inch up. While interest rates are still relatively low by historical standards, they can be expected to rise if inflation is expected to rise.

Higher interest rates can affect the economy in a number of ways, including:

Generally, rising interest rates are not friendly to a growing economy or to the stock market. However, in slowing the economy, it does have the effect of curbing inflation, which, if not controlled, could be much worse. Declining interest rates help stimulate the economy. However, if the economy grows to fast, it can trigger inflation.

Understanding how the direction of interest rates affects the economy can be helpful in properly positioning your finances and investments. However, understanding how interest rates interact with other economic indicators can be more predictive of future economic conditions.

With interest rates hovering around their historic lows, we’ve had it good over the last decade and we’ve become complacent as to their potential effect on the economy. If, as many economic experts believe, interest rates have hit bottom, there’s no place for them to go but up. It may be time to pay more attention to interest rates and their effect on the economy as well as your personal financial situation.