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Learning Center Experience
By Richard Carter, PhDFull-Time Faculty, Kaplan
UniversityPublished July 2016
Interest rates represent the cost of
money. As with most all economic theory, supply and demand is the cornerstone
for the cost of money. Understanding the Federal Open Market Committee (FOMC)
and its actions to manage the economy is the first step to find the source of
interest rates. The process is as follows:
Eight times per year the 12 Federal
Reserve Banks, acting collectively as the FOMC, assess economic conditions in
their respective districts. Retail activity, manufacturing growth, and rates of
employment are examples of data collected. A summary of their economic
assessments is presented in the FOMC
Beige Book. If the FOMC Beige Book
reports negative economic trends, the FOMC might consider taking actions to
lower the cost of money to prompt economic expansion.
When the FOMC opts to lower interest
rates the Federal Reserve Bank reduces your bank’s Federal Funds reserve rate.
This is a percent of cash “your” bank must keep in their vault and cannot lend.
As the Federal Funds reserve rate is
lowered, “your” bank now has excess cash; it is the not-lent cash previously
held in the vault due to the higher reserve rate. Banks are eager to lend this
excess cash since loans earn a higher rate of return than cash reserves. Loans
increase, the money supply increases, the cost of money goes down… an economic
The Composite Index of Leading
Economic Indicators (LEI) offer clues of FOMC rate changes. The weekly LEIs
note expected economic conditions about 6 months beforehand. Given this advance
notice, you would have an expectation how the FOMC might alter interest rates.
For example, a higher unemployment rate could suggest the FOMC will take action
to lower interest rates in the future. A listing of the 10 Leading Economic Indicators can be found via the link below.
Let’s say you are a Chief Financial
Officer (CFO) who might be considering the financing of projects at a time of
fluctuating interest rates. Much interest expense can be avoided when
borrowings are timed when rates work in your favor. Naturally, this also holds
true for mortgage rates. It could be costly for you to lock into a high rate
for the life of your mortgage.
A primary LEI is S&P
500 stock index trends. LEIs predicted stock market growth in 2008.
However, the 2008 stock market crash caught the experts off guard. The
crash destroyed $16.4 trillion of households' net worth from 2007 through 2009
and wiped out more than $2 trillion of retirement savings.
Visit the FAQ section for additional information on interest rates.
Dr. Richard Carter is a full-time faculty member
at Kaplan University. The views expressed in this article are solely those of
the author and do not represent the view of Kaplan University.
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