Interest Rates

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Bring current after I get the base info posted.

Interest Rates

Takeaway 1: When headlines say "Interest Rates are Low!", see which ones they are referring to. When assembling this essay, short-term rates were very low. Medium-term and long-term rates had not fallen like short-term rates. (Sep. 21, 2002. Now those rates have fallen considerably, so that all rates are low. This shows the lag inherent in the Fed's action on the short-term rates being communicated to the longer-term rates, which in turn affects the GDP. Without doing the detailed research, it looks like one year lag, in this case.)

Takeaway 2: The definitions are based on interest rates offered on securities by the US Government. To apply these terms to offers you see in the financial literature, you must adjust by recognizing the risk from corporate bonds is higher as well as the interest rates offered. And different corporations add different amounts of both risk and reward to the equation. This will be discussed in another essay.

Takeaway 3: This essay on interest rates deals with individual bonds, which have specific dates upon which the face value becomes due. Bond funds do not come due on a certain day and therefore have different investment characteristics.

I am always reading or hearing about interest rates, but I know less than I want about how to make them work for me in my portfolio. I recently read 'Maestro', the recent history of the Fed under Alan Greenspan by Bob Woodward. Here are some of the fundamental facts (current date April 23, 2002) that apply to interest rates.

Be careful when reading to note whether short, medium or long term rates are being discussed, because they have different characteristics and are affected differently by various policies. And they affect different parts of a portfolio.

Short-term rates

The Fed Funds rate, which banks must charge each other on overnight loans, is set by the Fed. It's the primary interest rate discussed when you hear the Fed raised or lowered the rates. These are typically the lowest interest rates available.

Other short-term rates (term 1 year or less) are based on the Fed Funds rate.

The business cycle underlies the predominant changes in this rate. The Fed changes this rate to try to calm inflationary forces and to maintain high levels of employment.

The current Fed Funds rate is 1.75%. One year ago it was 4.50%. (Sep. 21, 2002. 1.75%)

  • The entire change is under control of the Fed.
  • It is much lower than a year ago.
  • Your money market account is paying much less this year, but your principal has been preserved.

Medium-term rates

These are interest rates on bonds that come due in a couple of years up to those that come due in seven or so years. These rates are higher than the Fed Funds rate.

The excess over the short-term rate is an inflation premium for the length of the bond. That's a belief that beyond the current state there will be a withering away of the strength of the dollar by inflation. In the medium-term, changes like new method, new factories, the beginnings of new industries and life-style changes will affect the potential for growth in the economy without inflation.

A current medium-term interest rate is 4.66%. One year ago it was 4.71%. (Sep. 21, 2002. 3.08% )

  • The market determines this rate.
  • It is very slightly lower than a year ago. Increased inflation concerns were raised by the Bush tax cut, the terrorists attack, and the war on terror, however the base on to which the inflation premium was added is so much lower that the result is slightly lower medium-term rates than last year.
  • The principal amount in medium-term bond bought last year has gained some value. The interest rate you earn on a new medium-term bond is less than last year's.

Long-term rates

These rates are offered on bonds with maturities 10 or more years in the future. The definitions are not absolute, but are guidelines. These rates are often higher and often lower than medium-term rates.

The excess over the short-term rate is an inflation premium based on expectations over the longer term. In addition to the factors mentioned in the medium-term case, the federal deficit and the balance of payments come more into play.

A typical long-term interest rate is 5.22%. One year ago it was 5.08%. (Sep. 21, 2002. 4.08% )

  • The market determines this rate.
    • It is slightly higher than a year ago. Same comment as for medium-term however the projection is further into the future, so the uncertainty is greater. And uncertainty must be shown as an increase in risk which must be compensated by a higher interest rate.
  • The principal amount in a long-term bond bought last year has lost some value. The interest rate you earn on a new long-term bond is more than last year's.