The interest rate, a vital tool of monetary policy, is the amount charged, as a percentage of the initial capital, by a lender to a borrower for the use of assets, on an annual basis. In the US, the interest rate is in direct relationship to the country’s economy progression.
Once the economy is moving upward, citizens are given more job opportunities, thus increasing the prospects for saving under certain circumstances. Besides, the increasing demand for items such as houses and vehicles has caused an interest rate surge because the growing economy will further stimulate inflationary pressure and prices and the Fed has to prevent over-consumption and inflation.
When the economy slows down, the Fed will lower the cost of borrowing money to enable consumers and companies to afford more products and therefore boost the economy. Some other factors that might have an impact on the interest rate are short-term political gain, deferred consumption, alternative investments, investment risk, liquidity preferences, taxes and banks. The Fed has been aiming to evaluate as well as adjust interest rates in relation to the US economy for decades. Interest rates can be calculated as shown below:
- Simple Interest = P (principal) * I (annual interest rate) x N (years)
- Compound Interest =P (principal)*[(1+I (interest rate) N (months))-1]
History And The Major Indicators
Alan Greenspan, the Fed Chairman between 1987 and 2006, prompted a great “moderation” – moderate inflation, a low unemployment rate and stable economic growth. Following the collapse of the mortgage market under Ben Bernanke, the interest rate and inflation tumbled to a historic low as the Fed attempted to revive the economy. The economy was sluggish, and the goal was to increase the inflation level. As shown in the chart below, the inflation slumped from 4.1% in 2008 to 0.1% in 2009, followed by a rise to 2.6% in 2010. Janet Yellen, the new Fed Chairman, has taken action to stabilise the inflation to a relatively low level.
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2. Unemployment Rate
The unemployment rate, as the major indicator of economic change that causes adjustments of the interest rate, fell from an 8.9% average in 2011 to a 5.3% average in 2005 and further to a 4.9% average up to August 2016, showing a strengthening labour markets and an overall healthy economy. The average US unemployment rate between 1948 and 2016 is 5.82%. The current unemployment rate has dropped below the historical level, indicating the downward trend ahead.
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The US retail sales are projected to grow by 0.2% both year-on-year and monthly, while the inflation rate is expected to drop by 0.1%. As the inflation remains weak and the labour market heals, actions might be taken.
After raising the benchmark short-term interest rate from 0.25% to 0.5% in December 2015 for the first time since the financial crisis, Janet Yellen has made a widely expected move by announcing there is a possibility the Fed will raise the short-term interest rate again this month. This shows confidence in the economy, while many other countries are struggling.
Increasing interest rates will certainly enhance the performance of the US bond market but, on the other hand, it will weaken the stock market, which posts challenges to various investors. However, overall progress signals a rather optimistic future for the market. The impact on consumers is still undetermined because it brings lowers the interest on deposits for savers while increasing the cost of loans.
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