What does it mean when I read in the news that interest rates were lowered or raised?

Question

I was reading the newspaper, and an article mentioned that the government was going to lower interest rates. What does that mean?

I'm confused because the news always assumes that you know what they're talking about, but they're actually saying something completely ambiguous. Interest rates on what?

From my perspective as an individual with a bank account, there's two types of accounts where interest is applied:

1. Savings Accounts. Here, the bank is paying me interest on the money I give them. If interest rates go down, I'm sad.
2. Bank Loans. Here, I'm paying the bank interest on the money they gave me. If interest rates go down, I'm happy.

So when the news says that interest rates are going down, what do they mean with regard to:

1. Who is loaning-out the money?
2. Who is receiving the loaned-out money and paying interest?
3. Is it good for the people if the interest goes down?
4. How will it affect my Savings Account's interest rate?
5. How will it affect my Bank Loan's interest rate?

Answer 1

(US-centric answer, but should be fairly universal)

When the news says that the government is raising interest rates, it means the Federal Funds Rate that the Treasury gives banks on their deposits. However, raising or lowering that rate can have indirect effects on other rates that are the market's expectation of future government rates

Who is loaning-out the money?

The Federal Reserve (backed by the government)

Who is receiving the loaned-out money and paying interest?

Banks, via overnight loans

Is it good for the people if the interest goes down?

Generally, yes, since most people borrow more than they save. It also allows people to borrow money at lower rates, encouraging spending and investment.

How will it affect my Savings Account's interest rate?

It depends on the terms of your savings account. Banks can increase savings account rates to encourage saving if they get more interest due to higher government deposit rates.

How will it affect my Bank Loan's interest rate?

If your bank loan is at a fixed rate (like most mortgages), it won't be affected. Floating-rate loans typically reset their interest rate periodically (e.g. monthly or quarterly) based indirectly on the federal rates.

Note that there's a LOT more nuance to fractional reserve banking that is not covered here, but that's generally meant when the "government changes interest rates".

Answer 2

The Federal Reserve is a department in the government (debatably) whose job is to keep inflation steady. To do this, it has several tools at its disposal. Most of them work by affecting interest rates.

The job of a bank is to lend money and borrow money, make these match up with each other, and make a profit. When you put money in the bank, the bank is borrowing it from you. Notably, a bank borrows money for a short time (you can take your money whenever you want) but lends it for a long time (like a 30-year mortgage). The bank has to keep borrowing over and over until the mortgage gets paid back, or it'll go bankrupt. Banks actually do this fairly well. They can also borrow money from other banks, hedge funds, etc.

Sometimes they can't borrow. Sometimes nobody wants to put money in the bank this week for some reason. It can't just call in its mortgages, so it's bankrupt. It used to be that a bank somewhere in the USA would go bankrupt about every week.

Nobody likes this, which is why the government set up the Federal Reserve (the Fed, for short), the so-called "lender of last resort". If a bank is about to go bankrupt because it can't borrow any money this week, it can go to the Fed and say "hey look dude, can you give me $10,000,000 just to tide me over until my next paycheck?" and the Fed says yes. Notably, the Fed has infinite money. It can't run out. (In exchange for this, the bank has to follow a bunch of rules - all the time - and if it takes a Fed loan it has to pay more interest than it would like). This is called the discount window as it used to be an actual window where bankers would line up to get loans.

The Fed has to choose the interest rate for these loans, of course. Higher than banks would like, so they don't do it all the time, but not so high that it never happens.

Over time, the Fed got more abilities, like Reverse Repo and Quantitative Easing, and its main goal changed: instead of preventing banks from going bankrupt, it also adjusts the amount of money in circulation, to maintain steady 2% inflation. It still does this by affecting interest rates - as opposed to, say, giving or taking money from people's bank accounts. It affects the interest rate when it lends at a certain rate at the discount window; or when banks lend money to it at a certain rate (reverse repo); or when it buys or sells government loans (QE/QT).

The Fed's interest rate choices tend to ripple through the economy. If a bank can borrow money from the Fed at, say, 3%, then it definitely won't pay 4% on your savings account, because it would rather just get money from the Fed instead. But if your savings account is only 2%, the bank is getting a 1% discount. And if you borrow money from the bank, the bank makes a profit on that, so you might have to pay 4%. The bank wouldn't lend you money less than 2% because it would lose money.

So the Fed generally tries to keep its interest rates about the same as what they would be if it wasn't there, so banks rarely need to use it. But remember that it also has a job to keep inflation steady. And it does that by making the interest rate not the same as what it would be if the Fed wasn't there. When inflation is too low, the Fed tries to make people spend more money by decreasing interest rates below what they "should" be. This means borrowing money is cheap, so all these entrepreneurs with wacky business ideas can get loans from banks to start their businesses. And it means you don't get as much interest on your savings, so you think about saving less. Both of these increase inflation. When inflation is too high, the Fed does the opposite.

Just one problem: it doesn't work. Or at least, it didn't work after 2008, for some reason. The Fed set interest rates all the way to zero inflation was still too low! And so they kept interest rates at zero, for nearly a decade, and you couldn't get any interest in your savings account, while the likes of Jeff Bezos and Elon Musk got infinite free money, and the prices of houses and cars shot up like a rocket because you could afford to pay much more for the house because the interest was much less.

And all the inflation that didn't happen then is for some reason happening all at once right now, which is why they're increasing interest rates way up. If you see them decreasing interest rates any time soon, you should run far away, to a different country, because it means they suddenly don't care about inflation, and your country's currency could be toilet paper soon, just like Zimbabwe's.

Answer 3

Is it good for the people if the interest goes down?

That totally depends on your loans and investment portfolio.

I'd say that typically young people are expected to have more loans than bonds and money market investments (interest-bearing investments) in the investment portfolio. In this case, if interest rate goes down, it benefits you in three ways:

1. Inflation will skyrocket. Your salary will most likely skyrocket too. So in no time, the real value of your loans just went to near zero. Of course in this age when central banks want to control inflation, this may not happen immediately but will happen with a delay. I'm sure if central banks didn't do the mistake of negative interest rates for nearly a decade, we wouldn't have massive inflation now.
2. You will have to pay less interest, if you have a variable-rate loan. If you are planning to take a new loan (variable or fixed rate), it will be cheaper too.
3. If you are young and have investments, most likely those investments are in stocks (since stocks are the best long-term investment, and young people are most likely far away from retirement age). Stocks benefit massively from inflation. They are a real investment, so their return is real economic growth + dividend yield. Their nominal return is inflation + real economic growth + dividend yield. So a well-diversified stock portfolio will directly benefit from inflation. Also many companies have loans, those loans will be cheaper for the companies if interest rates are lower. Furthermore, reducing interest rates reduce the risk-free rate which directly benefits stocks since investors generally want a certain risk premium, so a reduced risk-free rate reduces the dividend yield they demand, increasing stock prices since dividends stay constant buy dividend yield reduces.

Of course, there are exceptions. There may be young people who have no loans and a small amount of savings in the bank account. If this is the case, you will suffer due to inflation and reduced interest on the bank account.

However, for older people, people near retirement age, reducing interest rates may be bad, since they have lots of fixed-income interest-bearing investments, and little stocks. However, whether this is bad or good depends on the duration of bonds in the portfolio. If the duration is longer than the expected time of using the savings, it may be beneficial given a constant inflation (reducing interest rates increase bond prices), but if the duration is shorter than the expected time of using the savings, it is directly harmful since some of the money needs to be reinvested at a lower future interest rate. Also skyrocketing inflation is harmful to bond investments, since most bonds have a fixed nominal rate rather than a fixed real rate.