Managing Investment Risk - Inflation and Interest Rate

Everything costs something. Interest is the cost of money. When interest rates go up, money becomes more expensive. This causes people to stop buying things on credit. Big ticket items, such as cars, houses, ad refrigerators, are often bought on credit. So, if interest rates go up sales of these items go down. The Federal Reserve manages the economy by controlling the cost of money; interest rates.

What is this scary thing called inflation? Inflation has been described as "too much money chasing too few goods." 'When this happens, the prices of goods will go up. Supply and demand. If prices go up too much, this could cause inflation to increase too much. There will always be come inflation around because you and I want our wages to increase. If you work for a bakery and want a raise, the bakery then must charge a higher price for bread to be able to pay the employees a higher wage.

I, on the other hand, as a consumer, see bread prices going up along with everything else, so I go to my employer and ask for higher wages so that I can afford the higher price of bread. It's a cycle. (Can you remember when ice cream cones cost 50 cents? I bet there are a few of you who can remember 10-cent cones!) Too much inflation, however, leads to economic problems.

The inflation police is the Federal Open Market Committee, which consists of 12 members: the seven members of the Board of Governors of the Federal Reserve System, the president of the Federal Reserve Bank of New York, and for the remaining four memberships, which carry a one-year term, a rotating selection of the presidents of the 11 other reserve banks. This committee, led by current Federal Reserve Chairman Alan Greenspan, affects every one of us. The committee meets every six weeks to evaluate how the economy is doing. This committee has been charged by Congress with keeping inflation at bay; doing so prevents recessions in our economy.

This committee controls inflation in the economy by raising or lowering the discount rate. The discount rate is the interest rate that the Federal Reserve charges its member banks when it loans them money (yes, even banks borrow money). If the discount rate is high, it discourages borrowing; if it's low, it encourages borrowing. This controls the money supply in the market. The banks make money by borrowing money from the Febs and then loaning it you, charging you a higher interest rate than they are paying. If it's too expensive to borrow, you won't buy that house or finance that car. This, in turn, slows down the economy and slows down inflation.

Higher interest rates are not bad for all consumers. Many retirees are delighted when rates increase because their CDs will pay them a higher return. On the other hand, a young couple will put off buying a house, or a businessman may not be able to afford the new equipment he needs for his startup business. This is what slows down growth in the economy.

Two other bank interest rates affect you. The federal funds rate is the rate that banks charge each other for borrowing. The rate you are charged as a consumer is the prime rate. Many other rates are tied to the prime rate, such as adjustable mortgages and credit card rates.