Let’s talk a little bit about short term interest rates in a layman’s language. The US Federal Reserve adjusts the short term interest rates according to market conditions. The most *popular* of these rates is the Federal Funds Rate - that’s the one you usually hear about on websites, TVs, and newspapers. This rate determines the interest that a bank pays in order to borrow money from another bank. If the Federal Funds rate goes down, banks can borrow the money (from each other) at a lower cost - and that eventually translates into lower borrowing costs for the customers (on various loans, credit cards, etc.,). If the rate goes up, the cost for borrowing money rises - for the banks and eventually for the customers.
Depending on how the economy is performing, the Federal Reserve attempts to adjust (raise or lower) the interest rate to keep it running in an optimal condition. This leads to sort of a interest cycle [it's more like a feedback control loop] which can be explained as below:
Here is a symbolic representation of the cycle:
Use this key to understand the above symbolic interest rate cycle:
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Bernanke worried |  |
Bernanke happy… yeah right! |
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Cramer angry |  |
Cramer |
[Watch this video if you are still confused]
Where are we now in the interest rate cycle?
Here is an excerpt from a CBS News article that succinctly describes the current situation.
The fear is that if credit continues to become harder for people and businesses to get, spending and investment will be crimped. That could hurt overall economic growth. In a worst-case scenario, the country could slide into a recession. Credit is the economy’s life blood. It allows people to finance big-ticket purchases such as homes and cars and can help businesses bankroll expansions and other things that can boost hiring …
… With squeezed homeowners finding it difficult to make their mortgage payments or pay them in a timely fashion, foreclosures and delinquencies are soaring and are expected to get worse. Lenders have been forced out of business, and hedge funds and other big investors in subprime mortgage securities also have taken a big financial hit.
This is pretty much indicative of the fact that we are heading towards a cut in the short term interest rates in the near future. In the present scenario, if this doesn’t happen soon, people are going to worried about recession.
This probably means that the market will have a greater tendency to go down in the coming days if there are no indications of reduction in the interest rates (or if there is no improvement in the housing market situation - which is not going to happen anytime soon, so let’s watch the interest rates instead). I guess we are seeing signs of it already - today’s headline on MarketWatch.com:
Dow industrials plunge 200 as investors give in to fear of recession.
I think i will prepare to buy some more ETFs today and in days to come.
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Wait a minute… isn’t “Cramer Angry” his normal state?
rstlne: No.. he is “mad” in his normal state. You should watch the video to get a taste of his “anger”.
I finally get it. Thank you for this post! And… the pictures are great
This only made it a bit more confusing for me lol
thanks Glob! I was trying to explain this to my friend the other day…
Always love the blog!
Lowering this rate will make it more difficult to sell Treasury securities to China and other countries, some of whom have hinted at selling their Treasury holdings. Who will finance Iraq?
Oh yeah.. forgot to mention this - and it took Mighty Bargain Hunter’s trackback (see below) to remind me.
Doesn’t Jim Cramer look like long lost brother of Ben Bernanke?
Or may be.. interest rate anxiety also promotes hair loss or something.
Haha! I love the inclusion of Cramer in the explanation
I hope you don’t mind, I’ve tagged you for Priscilla Palmer’s Personal Development List (http://chieffamilyofficer.blogspot.com/2007/09/personal-development-list.html).
Love the usage of the Bernanke and Cramer images. Cramer really has it out for Bernanke at this point. I do think the Fed needs to lower rates, but I think Cramer is going a little far with his criticisms.
It’s also interesting to note that as interest rates increase, mortgages become more expensive to repay each month. There are companies starting in the UK now that offer to buy back people’s houses for 80% of what they are worth and rent it back to them. Basically started as a way to help people who are in danger of their houses being repossessed.
So - interest rates going up is not always a good thing.
In the U.S. interest rate are going lower, Gold is going higher, Oil is going higher, inflation is going higher, the dollar is going lower. What is wrong with this? Everything! At some point the FED is going to have to raise rates bigtime. We are in a very, very, precarious situation at the moment. I think Gold will tripple to over $2,000 an ounce when the market finally wakes up and sees the real inflation. Last I checked a lower dollar = higher import prices. There is no inlfation deflator here. With commoditioes on fire you can forget about that. Bernanke should have never lowered rates last week. However, the Fed might be doing something that few have talked about. Maybe the Fed has abandoned the dollar the crush teh trade deficit. Good luck, it will take 20 years to correct our 6% of GDP trade deficit and move it back to under 1% of GDP, unless you want to seriously disrupt the global economy. We are in for tough times people. Very tough!
Ames: I think you are right. I cannot make a judgment as to whether the Fed did the right thing or not, but I think things are going in opposite directions right now. I hate to think what’s going to happen when inflation and credit crunch hits at the same time. Is that what they call “stagflation”. With the recent jobs report, rising oil prices, and the horrible real estate mess - I think we are on the edge of something like that.
golbguru,
Thanks. We shall see. I am deeply worried. I see the dollar collapsing by 2012.
Regards,
Ames
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