Question

Use the following information to work. From 2009 through \(2012,\) the long-term real interest rate paid by the safest U.S. corporations fell from 4 percent a year to 2 percent a year. During that same period, the federal funds rate was roughly constant at 0.25 percent a year. How does the federal funds rate influence the long-term real interest rate?

Short answer

The federal funds rate sets a baseline for interest rates, but other economic factors affected the fall in long-term real interest rates from 2009 to 2012.

Step-by-step solution

Understand the Concept of Federal Funds Rate

The federal funds rate is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) overnight. It influences the economy by affecting borrowing costs.

Identify the Relationship

The federal funds rate serves as a benchmark for other interest rates, including long-term real interest rates. When the federal funds rates change, it influences economic activity and expectations.

Analyze the Given Period

From 2009 to 2012, the federal funds rate remained relatively constant at 0.25 percent a year. This constancy suggests the Federal Reserve aimed to keep short-term borrowing costs low.

Examine Long-Term Real Interest Rates

During the same period, long-term real interest rates for the safest U.S. corporations decreased from 4 percent to 2 percent a year. This indicates other factors influencing long-term rates besides the federal funds rate.

Connect the Dots

Given the stable federal funds rate, the drop in long-term real interest rates could be attributed to lower expected inflation, decreased demand for borrowing, or other economic policies or conditions.

Conclusion

While the federal funds rate remained constant, other factors led to the decrease in long-term real interest rates. The federal funds rate sets a baseline, but expectations and economic conditions greatly affect long-term rates.

Key concepts

Long-Term Real Interest Rate

The long-term real interest rate is an important concept in economics and finance. It represents the interest rate on loans or investments after adjusting for inflation over a longer period. Unlike nominal interest rates that you might see advertised, real interest rates help you understand the true cost of borrowing or the real return on your investments.
For example, if you take out a 10-year loan, the interest rate you'll pay after accounting for inflation is the long-term real interest rate. It is crucial because:

• It helps borrowers understand the true cost of their loans.
• It allows investors to gauge their actual returns.
• It influences decisions on savings and spending.

Movements in long-term real interest rates can signal changes in economic conditions and policies.

Borrowing Costs

Borrowing costs are essentially the expenses incurred when you take out a loan or any other form of credit. These costs are heavily influenced by interest rates. When the federal funds rate is low, as it was from 2009 to 2012 at 0.25%, borrowing costs for short-term loans also tend to be low.
Several factors determine borrowing costs:

• Interest Rate: The higher the interest rate, the higher the borrowing cost.
• Loan Term: Longer loans usually cost more due to extended interest accumulation.
• Creditworthiness: Better credit scores often lead to lower borrowing costs.

Lower borrowing costs can stimulate economic activity by making it cheaper for businesses and individuals to invest and spend.

Economic Conditions

Economic conditions refer to the overall state of an economy at a given time. These include factors like GDP growth, unemployment rates, inflation rates, and consumer confidence. From 2009 to 2012, economic conditions were turbulent due to the aftermath of the 2008 financial crisis.
Economic conditions influence interest rates and borrowing costs:

• In times of economic downturn, central banks like the Federal Reserve often lower interest rates to stimulate borrowing and spending.
• During economic growth, interest rates may be increased to prevent overheating and control inflation.

In our example, the stable but low federal funds rate suggests that the Federal Reserve aimed to support economic recovery during a challenging period.

Expected Inflation

Expected inflation is the rate at which people anticipate prices to rise in the future. It plays a crucial role in shaping interest rates. When inflation expectations are high, lenders demand higher interest rates to compensate for the decreasing purchasing power of future repayments.
Conversely, when inflation expectations are low, interest rates generally remain lower. Why is this important? Because:

• Lenders and investors use expected inflation to set interest rates.
• Businesses consider inflation expectations when planning investments.
• Individuals factor it into their saving and spending habits.

From 2009 to 2012, lower expected inflation likely contributed to the decrease in long-term real interest rates.

Interest Rate Benchmarks

Interest rate benchmarks are standard rates that serve as reference points for various financial instruments and loans. The federal funds rate is one such benchmark. Other common benchmarks include the LIBOR (London Interbank Offered Rate) and the prime rate set by banks.
Interest rate benchmarks are important because:

• They determine the cost of borrowing across different financial products.
• They influence investment decisions and risk assessments.
• They provide a measure for comparing rates across different time periods and regions.

In the period from 2009 to 2012, the federal funds rate at 0.25% served as a crucial benchmark for influencing and stabilizing other interest rates in the economy.