3 Things You Need To Understand About Interest Rates

Jay Soloff
February 18, 2015
In the world of economics and finance, there is hardly anything more important than the role of interest rates.  Nevertheless, how interest rates truly function happens to be one of the most misunderstood concepts in the business world. Perhaps the complexity of the subject results in mixed or inaccurate messages being relayed to the public.  Or maybe it’s just too boring for most people to take the time to understand.  (Let’s try not to draw any conclusions about economists.)

But here’s the thing…

You don’t have to master all the details of how interest rates work, be an expert on monetary policy, or understand the dynamics of global currency fluctuations.  Instead, just focus on what’s truly important for your business. I’ll make it easy for you.  Here are the three things you should know about interest rates:

Higher Rates Don’t Have to Mean Less Consumer Spending

When the Fed raises interest rates, it’s typically done to combat inflation.  Inflation is generally the result of increased consumer spending.  However, just because rates go up doesn’t mean consumers are just going to quit spending. Keep in mind, consumers tend to spend more because they’re making more, or they’re more confident in the economy.  A hike in rates is an effort to encourage more savings (and thus slow inflation).  However, as the economy improves, consumers will have a bigger slice of the pie to use for both spending and savings.  So, it’s possible to see rates go up and spending go up at the same time.

Higher Rates are Both Good and Bad for Debt

Most people assume higher rates are bad for businesses because it makes borrowing money more expensive.  Of course, this is absolutely true.  A bank loan with a 3% interest rate is more favorable than a bank loan with 6% interest, all else being equal. However, one thing many do not realize is higher rates also make debt a better investment.  Fixed income (debt) investing will provide greater returns the higher interest rates go.  For a company looking for someplace to park their excess cash, a higher rate environment is almost always a more favorable situation to be in.

Higher (or lower) Rates Aren’t Always Going to Correlate with a Higher (or lower) Dollar

You’ll often hear people lament about how low interest rates will debase the US dollar (or how higher rates will make the dollar expensive).  In theory, higher/lower rates should result in a higher/lower currency value, assuming you only have one currency to think about. Yet, we live in a world of multiple currencies.  And the only thing that really matters is how currencies are valued relative to each other.  As such, interest rates are only part of the picture. For example, with US interest rates at historical lows, you’d expect the US dollar to be cheap relative to other currencies.  However, the US economy is by far the strongest economy in the world at the time of this writing.  Subsequently, many investors are purchasing dollar-dominated securities, and avoiding investments in weaker economic regions such as Europe and China.  As a result, the US dollar has been one of the strongest currencies for the past year.

And There You Have it...

If you understand those three concepts, there’s not much else you need to know about how interest rates impact your business.  In fact, the third item really only applies if you do business internationally.  For a company that does all its transactions in dollars, the first two items should cover most of the important info about rates. Yes, interest rates can be complicated.  The key is to focus on what’s most important to your business.  For everything else, just let the economists worry about the details.

About the Author

Jay Soloff

I believe I bring a unique perspective to my work as I have the skills and experience to thrive as both an investments/markets analyst and writer. As an analyst, I bring an extensive background in investments. That includes becoming a floor trader in Chicago, a trading software consultant on Wall Street, a hedge fund analyst, and an editor of multiple subscription-based investment newsletters. As a writer, I'm accomplished at producing informative, blog-like articles as well as creating in-depth research reports.

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