The interest rate, like gas prices and hemlines, goes up and down depending on how the economy is doing. Just this month, the Federal Reserve increased the interest rate again, making the interest rate hikes over the past year one of the fastest in history.
Interest rates can have a significant impact on the economy and can especially influence the earnings from certificates of deposit (CDs) and savings accounts. We look at how these interest rates are determined, plus how their movement affects these accounts.
How Are Interest Rates Determined?
The Federal Reserve determines interest rates in the United States through something called the Federal Funds rate. The Federal Funds rate is the interest rate at which banks lend to each other overnight to meet their reserve requirements. The Federal Reserve sets a target range for the Federal Funds rate and then uses open market operations to influence short-term interest rates to stay within that range.
What are open market operations? They are the buying and selling of government securities on the open market. When the Federal Reserve buys securities, it increases the money supply and puts downward pressure on interest rates. Conversely, when it sells securities, it decreases the money supply and puts upward pressure on interest rates.
Lower Interest Rates
Lower interest rates can have several impacts on the economy:
● Boost in the housing market: It can lead to increased demand for homes, since mortgages become less expensive. This can push up home prices and lead to an increase in construction, creating jobs in the housing sector.
● Higher inflation: When consumers and businesses borrow too much and too quickly, it can lead to higher inflation or an asset bubble that overvalues certain sectors of the economy and may eventually burst.
● Increased borrowing and spending: Lower rates make borrowing money cheaper. This woos consumers and businesses to borrow and spend more. Economic growth is given some oomph and can jumpstart job creation.
● Lower interest on debt: Lower interest payments on government and consumer debt frees up money for spending or reinvestment.
● Revitalization of the stock market and investing: This can lead to rising stock prices, since it makes it easier and cheaper for companies to borrow money. A lower discount rate and cost of borrowing can also lead to increased investment by firms, which can also stimulate the economy.
Higher Interest Rates
Higher interest rates affect the economy in different ways.
● Decreases borrowing and spending: Higher borrowing costs for consumers and businesses mean that they are less likely to borrow money. This leads to a decrease in spending, which can slow down economic growth and sometimes lead to a recession.
● Decreases demand for housing: Mortgages become more expensive. This leads to a decrease in demand for homes and eventually a decline in housing prices. Construction activity dwindles, and job losses occur in the housing sector.
● Helps control inflation: They can also help control inflation by discouraging lending and borrowing.
● Lower business investment: Higher interest rates can lead to lower investment by companies, since the cost of borrowing becomes more expensive. This can lead to economic stagnation and higher levels of unemployment.
● Lower inflation: Higher interest rates can help to lower inflation, since it discourages borrowing, limits demand, and reduces spending. This helps to control inflation.
Interest Rates and CDs
So, how do interest rates affect certificates of deposit (CDs)? Because CDs are a type of savings account that offer higher interest rates than traditional savings accounts, their yield depends on what the interest rate happens to be.
How do CDs operate?
Choose a CD: First, select a CD with a fixed term. These range anywhere from three months to five years. During this time, the CD's interest rate stays the same.
Deposit money: Next, deposit money into the account. Some banks may have a minimum deposit requirement to open a CD. The funds cannot be withdrawn before the CD matures without paying a penalty.
Earn interest: The interest rate on a CD is generally higher than that of a savings account but lower than some other investment options. The interest earned is dependent on the CD's term, interest rate, and method of compounding.
Wait for maturity: Finally, when the CD matures, you can either cash out the money or roll it over into another CD. If you withdraw the money before maturity, you will most likely pay a penalty fee.
When interest rates rise, the rates offered on CDs also tend to rise. Investors can earn more interest on their CDs. When interest rates fall, the interest rates on CDs will generally fall as well, which can result in lower returns for investors.
Interest Rates and Savings Accounts
How do interest rates affect your savings accounts? These accounts also earn interest, and the interest rates offered on savings accounts tend to rise and fall along with interest rate changes.
Bank savings accounts allow customers to store their money and earn interest on their deposits.
How do they work?
Deposit funds: You deposit money into the account through a cash deposit, online transfer, or by setting up direct deposit from your paycheck.
Earn interest: The bank pays interest on the money in your account based on the interest rate at the time and other terms like the compounding frequency.
Withdrawal: You can withdraw your money from your savings account when needed. Most savings accounts have limits on the number of withdrawals that can be made in a month without incurring fees.
When interest rates rise, the interest rates offered on savings accounts also tend to rise, meaning that savers can earn more interest on their savings. On the other hand, if interest rates fall, the interest rates on savings accounts will generally fall as well, which can result in lower returns for savers.
Overall, interest rates play a critical role in the returns for savings vehicles like CDs and savings accounts. While rising interest rates can be beneficial for those looking to earn more on their savings, it's important to keep in mind that other market factors can also impact the overall returns of these investment vehicles.