And Why Aren’t They Driving a Ferrari?
I’ll give you a multiple choice list of answers for this one
- Janet Yellen, the Fed Chief
- Someone in a back office on Wall Street
- All of us
- It doesn’t matter, the economy follows a random walk
Trick question, there’s no one answer but “all of us” comes pretty close. That being said, the Federal Reserve and how they set interest rates can have a large effect. Did your eyes just glaze over when you saw “Federal Reserve” and “interest rates”? You’re not alone. Let me take a minute, however, to explain interest rates in a different way.
Think of interest rates as brakes.
The economy is made up of so many different moving parts from the grocery store manager who decides to sell apples at a certain price to an entrepreneur designing a new product for the future that there is no way to determine any one driver of the economy. However, the Federal Reserve Committee which decides how much interest they will charge banks to borrow has a large foot on the brakes of the economy.
If you have money in a savings account at the bank, you know interest rates are low because you aren’t earning much on the money that sits there. I like when my bank gives me a high interest rate on my savings in the bank. But when I take a loan, for a home or car or some other use, I prefer a low interest rate. The interest rate is really the cost of borrowing money.
If the cost of borrowing money is low, you might expect more people to borrow, just like if the cost of a candy bar is low, you’d expect more people to buy it. If an economy is slowing down, the idea is to lower interest rates so that more people can borrow and spend that money on things like building businesses or going on vacation.
The Fed can also increase the cost of borrowing by raising the interest rate. The idea is to slow down borrowing and take some of the wind out of the economy. This is their version of brakes to keep the car from going so fast it spins out of control.
What you really want is a nice, steady pace for the economy. The Fed tries to make that happen by raising and lowering interest rates. The next time you hear or read that the Fed is raising interest rates, just translate it to tapping on the brakes of the economy. And when they lower interest rates, think, taking their foot off the brake so we can coast a little faster.
Here’s to some happy coasting.
Kristin Rodriguez