Interest rate markets are a poorly understood but vital part of the U.S. and world economy. They impact how much a government pays to run a deficit, how much you pay for a mortgage and how much (or how little) interest you receive on your savings account. Short-term rates are affected by different forces from the long end of the interest rate market, or yield curve. Despite the different influences, long-term interest rates typically exhibit more volatility and rate movement than short-term rates.
Short-term interest rates are strongly influenced by the United States Federal Reserve (the Fed) and the European Central Bank (ECB). The ECB has a single mandate: Keep inflation under control. However, the Fed has a dual mandate: Combat inflation and keep unemployment at or near the “natural” rate of unemployment.
Central Bank Influence
The Fed and ECB influence inflation by changing the interest rate at which they lend money. Both central banks serve as primary lenders to the largest and most structurally important banks. These large banks lend to smaller banks, and so on, down to the local bank branches that lend to consumers. The short-term lending from the Fed and ECB tightens and loosens the money supply. By making money more expensive (raising the interest rate), the central banks apply braking pressure to an economy that is starting to heat up.
Inflation can be thought of as the decrease in the value of money over time. As any economy grows, the value of money is degraded and the old paper money that is printed loses value. If this happens too fast, the economy can grow too quickly and set up a boom-bust cycle. By moderating the pace of growth, central bankers attempt to foster an environment of slower but sustained growth.
Interest Rate Targets
Short-term interest rates are irrevocably tied to the central bank rates. The typical yield curve is upward sloping, meaning interest rates rise as you look at longer duration interest-bearing assets. The Fed acts on a regular schedule to set interest rate targets. When the Fed or ECB changes its rate targets, the interest rate markets, especially the short-term instruments, react quickly and move in the same direction as the central bank targets.
Long-Term Interest Rates
The longer end of the yield curve is more speculative and forward looking. Over the term of the instrument, it is expected that an investor will earn a return that pays him a premium over the rate of inflation. By their speculative nature, long-term interest rates exhibit more volatility and rate swings as inflation expectations change over time. Long-term rate volatility can change the Fed rate targets. If investors expect no or low inflation, their investment decisions force long-term rates down, sometimes below short-term rates. This situation, with high short-term interest rates and low long-term rates, is known as an inverted yield curve.
- "Economics of Money Banking and Financial Markets"; Frederic S. Mishkin; 2003
- graph of the succes image by Attila Toro from Fotolia.com