Understanding the rise and fall of interest rates might seem complicated but can easy be explained if you understand the basics of economy. Supply and demand of credit influences the height of interest rates and you can consider the fluctuations in interest rates as the barometer of the economy.
The level of interest rates on savings tend to be higher in times when the economy is growing fast and lower in times of inflation and recession. We notice the contrary if we borrow money; the interest rates will be lower when the economic circumstances are good and rise when there is a recession, high unemployment or any other reason which affect our economy negatively.
Interest rates are important for everyone and can be considered as the motor of the economy. Lower interest rates make it easier for companies to borrow money if they want to make investments. In times of recession they can easier borrow money and this will stimulate the economy to grow again.
There are two kinds of interest rates: short-term and long-term interest rates. The Fed can only change the short-term rate but in many cases the long-term interest rate will follow the same trend. They will likely decrease the interest rate when the economy is growing too fast and if inflation is too high. In times of a slow down of the economy and certainly during a recession they will increase the interest rates. This central bank which is responsible for the monetary policy will take the necessary steps to keep our economy healthy.
Inflation is probably the main reason why interest rates rise and fall. The average prices of goods are rising faster than the supply of money. Money is losing value and people will not be able to buy the same quantity as goods. A huge increase in demand and a fall in supply cause this economic situation and interest rates will fall.
We notice often inflation in times of fast risen oil prices. The oil price might be not the cause of inflation but affects the prices of all products. Expenses of fuel increases and every company incorporate the extra cost when they sell other products and will often cause inflation. Political situations, for example problems in the Middle East and countries where they export oil cause an increase of oil prices because of expectations that there will be not be enough oil available. They expect that the demand will be higher than the supply of oil and result in higher oil prices.
The value of the dollar is an important factor which can cause the rise and fall of interest rates. An increase of the value of the dollar can increase oil prices and lead to inflation and interest rates will be decreased. A decrease of the value of the dollar can have the opposite effect; it is always a combination of several factors which determinate the exact oil prices but has often an impact of the economic situation of the world economy.
The rise and fall of interest rate has also an impact on the stock market. An increase of the interest rates has not immediately an impact on the stock market but in the long run the companies will make less profit and more people will sell their stocks with the consequence that the value of the stocks will drop. A fall of the interest rates will benefit people who have mutual funds which invest in bonds. The fund company can sell the bonds with higher rates and buy new with lower rates and will cause a rise in the value of these mutual funds.
There are several reasons why interest rates rise and fall, but we can consider inflation as the key of this effect. The interest rate represents the price to use money and the level can be compared with the weather circumstances. We will receive a higher interest rate on our savings in times where inflation is low, and the economy is growing but we will pay more to borrow money. Everyone is happy when the sun shines, and this can be compared with a good economic climate. People have less debt and the Fed is a vital institution to take action for a healthy economic climate.