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Interest Rate Outlook: How Interest Rates May Impact Our Personal Financial Goals

BACKGROUND

The chart above reveals a great deal of information regarding the relationship between recessions and interest rates. The shaded areas indicate the depth or duration of the recessions since 1990, and as you can see we have already been in the current recession more than twice as long as the previous two. Understanding the relationship between interest rates and recessions may help us to better manage our personal finances. For many years, Federal Reserve Bank (the FED) interest rate policy has been a driving force behind both the domestic and international economies. Fed interest rate policy drives the wheels of commerce because FED policy affects the availability of funds for investment at all levels. When rates are high it is more expensive to undertake new initiatives such as expanding a factory’s capacity or even buying a new car. When rates are low it is possible to trigger inflation as it costs less to “borrow and buy” at each level in the economy. It would serve each of us very well to understand and even anticipate future interest rate moves in order to successfully manage our personal finances. The level of interest rates impacts the cost of corporate borrowing, home mortgage expense, consumer credit costs, and the potential return on our investments. There are a number of key factors which impact interest rate decisions by the FED: gross domestic Product (GDP), employment numbers, the consumer price index, the producer price index, consumer credit levels, and housing starts are the most influential of these factors.

GROSS DOMESTIC PRODUCT (GDP)

I have discussed GDP before in articles on this web site, so suffice it to say that GDP - the output of goods and services produced by labor and property located in the United States - is the most important economic indicator published. A larger-than-expected quarterly increase or increasing trend is considered inflationary, causing concern the Fed might need to intervene and raise interest rates in order to slow growth. Conversely, a negative growth, or economic downturn may cause the Fed to lower interest rates to stimulate the economy and increase the growth rate. We are currently experiencing the latter scenario, and interest rates remain at historically low levels. The FED was forced to take these actions during the financial crisis which began late last year and largely remains with us at this time. Until there are several successive up ticks in GDP the FED will be forced to maintain the current rate policy.

CONSUMER PRICE INDEX

The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a fixed market basket of consumer goods and services. The CPI is considered the most important measure of inflation. The CPI for All Items less Food and Energy (also sometimes referred to as the "core" or "underlying" CPI) excludes volatile food and energy prices. Analysts focus on the "core" CPI, which is considered a more accurate measure of the underlying rate of inflation. A higher-than-expected CPI or increasing trend is considered inflationary, and can cause bond prices to fall and yields and interest rates to rise. Likewise, a lower-than-expected CPI causes yields and interest rates to fall.

PRODUCER PRICE INDEX

The Producer Price Index (PPI) is a family of indexes that measures the average change over time in the selling prices received by domestic producers of goods and services. The PPI measures price changes from the perspective of the seller, and offer insight into future consumer price direction. This contrasts with the Consumer Price Index (CPI) that measures price change from the purchaser's perspective. The PPI can be volatile. It is best to use the six-month to one-year moving average. A higher-than-expected PPI is considered inflationary, and can cause bond prices to fall and yields and interest rates to rise. Likewise, a lower-than-expected figure causes yields and interest rates to fall.

EMPLOYMENT SITUATION: UNEMPLOYMENT RATE

Just released at time of publication: 467,000 more jobs lost in June, rate hits 9.5%) The government's employment report provides information on the unemployment rate and the number of unemployed persons by occupation, industry, duration of unemployment, and reason for unemployment. It reflects historical data…what happened last month…therefore it is a lagging indicator. Nonetheless, it is extremely important. A higher-than-expected unemployment rate is considered detrimental to growth, and therefore can cause bond prices to rise and yields and interest rates to fall. A lower-than-expected unemployment rate or declining trend is considered inflationary, and can cause bond prices to fall and yields and interest rates to rise.

HOUSING STARTS

Housing starts is one of the leading economic indicators. A higher-than-expected increase in housing starts triggers economic growth and is considered inflationary, causing bond prices to fall and yields and interest rates to rise. Currently, we are experiencing a decline or declining trend in housing activity which in turn slows the economy and has pushed it into a recession, causing yields and interest rates to fall.

HOW TO USE THIS INFORMATION

The most important point to remember about the economic indicators described above is that they do impact our personal financial well being because the FED sets interest rates based upon these very indicators. Interest rates directly impact all investment vehicles, therefore these indicators are certainly worth tracking and studying at least at a basic level. This information is easily obtained, as it is reported systematically in all of the financial press and through all the financial broadcast media. By tracking this data, and the usual analysis that accompanies its release, we can make better decisions on how we deploy our investment resources. For example, in times of severe recession (the present), when caution is warranted, much of our investment capital may be in time deposits, savings accounts, or money market accounts. Tracking the above indicators will help to determine the duration we choose for these cash market instruments. If there is an attractive rate on 2 year CD’s and the indicators show very little near term promise for a turn around, we may do well to take advantage of the 2 year offering, especially if the longer duration CD’s (3 year, 5 year) are paying little more interest than the 2 year. As we move forward and begin to see improvement in the various indicators, we may choose longer durations for our cash deposits as we see rates rising in the 3 year to 5 year spectrum. Furthermore, if we begin to see successive monthly improvements, we may choose to move money from cash to stocks or other investments in anticipation of better times ahead. In conclusion, the more in tune we are with the key economic indicators, the better we can anticipate interest rate changes, and the better equipped we will be to make the best financial decisions for ourselves and our families.



©Patrick J. Catania 2009 The views and opinions expressed herein are solely those of the author and do not necessarily reflect those of Baxter Credit Union, its Board of Directors, or its employees. The author is responsible for the content. Readers should consult with, and seek professional advice from their own attorneys, accountants, and financial advisors with respect to their individual financial needs and circumstances. We welcome your feedback and ideas regarding this service. To submit a comment or idea for a future article, please email us at member.feedback@bcu.org