What is noteworthy is that markets do not think about the impact on interest rate on an immediate basis. They are more concerned about the effect it will have on the financial markets over a long period of time. For very obvious reasons, the longer you are lending, the higher are the rates you charge. For instance, if you are borrowing from a federal bank overnight, for a one-year term or a 10-year term, the bank interest rate that you pay will be increased progressively. This is to cover the uncertainty factor. You obviously have more control over what could happen overnight than what can happen over a period of one year or 10 years.
Yield curve is the term used to describe the variation in cost of borrowing over a period of time. Though there are different factors which decide lending considerations over different time spans, yet the common factor is that any change in interest rate anywhere along the curve can send a chain reaction over the rest of the line. A fine example of this behavior is the mortgage rate. At any point in time, when the interest rate looks to go southward, the entire chain of the yield curve will also tend to dip. The high disparity in overnight lending rates and the rates for a 10-year period signals a sharp increase in inflation. Alternately, it can also be perceived as a sign of the deteriorating creditworthiness of the government over the next 10 years.
The recent economic crisis has shown that when the government is forced to pay higher interest rate, it has no option but to dip into public finances. According to experts, the writing is already on the wall that for every dollar that the government collects in taxation, it will have to spend several times that amount toward interest on national debts in the coming years. This is exactly the sort of situation that pushes a country toward financial crisis.
Having seen the impact that increasing interest rate can have on the overall financial health of a countryâ€˜s economy, it is important to understand the reasons that affect the rates. As in any dynamic market, the forces of demand and supply determine the rates. Inflation is of course the primary reason for increase in lending rates. Lenders secure their money by adding expected inflation value to the lending rates. As discussed earlier, long-term loans are by nature a risky instrument because of the uncertainty factor associated with it. As there are chances of default in payments, such term loans are charged higher rates of interest.
Interest rate comparison among various lending instruments reveals that long-term loan lending rates are higher in any loan element.
Interest rate is the key driver in any free market economy. The subject is broad and complex. It has a direct impact on the personal living standard of individuals in any economy, and its proper management is vital to the sustenance of the financial health of a country.