Interest rates are one of the major drivers of our economy, setting the pace for investment markets. Learning how interest rate changes can influence the marketplace can also help you understand how they impact your wallet.

Who Sets Interest Rates?

The role of determining certain interest rates belongs to the Federal Reserve Board (also known as the “Fed”), an independent central banking organization created by Congress in 1913 to direct the nation’s monetary policy. The Fed mainly consists of three parts: a Board of Governors, 12 Federal Reserve Banks and the Federal Open Market Committee (FOMC).The Fed has the power to set two important short-term interest rates:

·    The Discount Rate. The rate the Fed charges to lend money to large, eligible banks.

·    The Federal Funds Rate. The rate large banks charge to lend reserves to other banks that need short-term funds. This rate may change on a daily basis in response to market activity; however, the FOMC has the ability to target a specific rate.

How Do Interest Rate Changes Affect The Economy?

As the Fed raises or lowers short-term interest rates, banks may raise or lower the interest rates they charge borrowers, including the prime rate. Changes in the prime rate may affect:

·    You individually. Banks use the prime rate to set rates for credit cards and consumer loans. If you have an adjustable-rate mortgage or a credit card that has a rate tied to the prime rate, payments may rise or fall according to the prime rate.

·    The whole economy. A change in the prime rate may affect the overall economy in several ways. For example, an increase may result in fewer consumers taking auto loans, which in turn may cause a slowdown in the automobile industry. On the other hand, when interest rates fall, businesses find it easier to finance expansion and other activities. Typically, increases in interest rates slow economic growth because consumers have less money to spend and less motivation to borrow. Conversely, if interest rates drop, the economy may benefit from increased spending.

It’s also important to note that generally, as interest rates rise, the value of your investments (particularly bond investments) may decrease. This is known as interest rate risk. While all types of bonds are subject to interest rate risk, you may reduce the risk somewhat by choosing a fund that holds bonds of a shorter duration or average maturity.

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