Interest rates impact the cost of borrowing money as well as the returns that savers can earn on their investments. When interest rates rise, loans become more expensive but rates paid on deposits also rise. When rates fall, loans become less expensive and yields on savings also drop. Consumers tend to borrow more when rates are low and save more when rates are high but other issues can complicate the general patterns of behavior.
Interest rates are only meaningful when compared against a barometer of some kind, and for consumers the barometer usually ends up being the inflation rate. In isolation a 10 percent interest rate on a loan sounds expensive, but if you can borrow a mortgage at 10 percent in an inflationary environment where the cost of goods keeps rising at an annual rate of 15 percent, the loan rate sounds inexpensive. Conversely, in a deflationary environment when prices are falling and commodities values are dropping, a 1 percent return on a savings account sounds very attractive. Therefore, consumer behavior does not change based on rates alone but rather on the rates in relation to the wider economy.
To prevent inflation rising rapidly, the government can raise the interest rates that banks pay to borrow money from the Federal Reserve Bank. To remain profitable, banks pass on the increased costs to borrowers by raising rates on loans and credit cards. Consumers have to change their borrowing habits if interest rates cause borrowing to become too expensive. A slowdown in consumer spending slows down inflation because sellers have to lower the prices of goods in order to make sales in an environment where consumers have less disposable income due to more of their money going to borrowing costs.
When interest rates are very low in relation to the inflation rate or even fail to keep pace with inflation, consumers must change their savings habits, otherwise they lose spending power over time. Consequently, consumers are more inclined to take risk with their money when yields are low on conservative investments such as bonds and bank deposit accounts. Some conservative investors start investing in stocks because in their mind the risk of making no returns on a conservative investment outweighs the risk of losing principal by investing in volatile growth securities that have no principal protections.
When savers can only earn minimal yields on short-term investments lasting 12 months or less, they are more inclined to invest in longer-term instruments. Borrowers faced with high interest rates are more inclined to take out short-term loans or variable-rate loans with the hope and expectation that rates will eventually fall. When rates are very low, borrowers are likely to lock in fixed rates on long-term loans such as mortgages before rates have a chance to rise.
- Federal Reserve Bank of San Francisco; About the Fed; 2010
- "The Wall Street Journal"; Prime Rate: Frequently Asked Questions; 2011
- Federal Reserve Bank of St. Louis Economic Data. "Effective Federal Funds Rate." Accessed Oct. 13, 2019.
- Federal Reserve Bank of St. Louis Economic Data. "Inflation, Consumer Prices for the United States." Accessed Oct. 13, 2019.