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Thinking About Rates

by Fred Cederholm
In the past six years interest rates have bobbed up and down like a cork in the mid-Atlantic during a perfect storm.
I’ve been thinking about rates. Actually I’ve been thinking about corks, the Open Market Committee, benchmark rates, and background. In the past six years interest rates have bobbed up and down like a cork in the mid-Atlantic during a perfect storm—up, down, and now up again.

You see, in an effort to smooth out the crests and troughs of the American economy, the Open Market Committee of the US Federal Reserve Bank has taken interest rates from their highest level in almost twenty years to the lowest in over fifty years. Now, the pendulum swings back ever so slowly. I fear the Fed’s policies have accentuated problems, not fixed them!

Yearly interest on the national debt increases $20 billion for every quarter point rise in the federal interest rate.

When the Fed raised rates a quarter of a point for the eleventh time in that many months on September 20th, I began a column on interest. A national debt of $8 TRILLION costs Uncle $ugar an additional $20 BILLION in yearly interest for every quarter point (.25%) increase. I was attempting to flag the impending "category 9" financial hurricane that will hit the national government, many state and local governments, and every household across the nation burdened with near 100% financed real estate and/or carrying mega-credit card debt.

This column was mind-boggling and mind-numbing, both because of the sheer scope of numbers involved and because the differing benchmark rates (hardly part of everyone’s daily vocabulary, though they should be) are so misunderstood. Two rates that I (and the bankers I had audited) have erroneously used interchangeably for twenty-plus years were really distinctly different.

I usually pre-screen my technically oriented columns using a diverse group of friends and neighbors (and read them aloud to my little black Scottie, Macintosh II) before they are published. The feedback on this one was a universal "huh?" And, Mac II crawled under the bed before I finished! I really needed to lay some foundations in the definitions and the historical background for the column to make any sense.

There is a time value to money saved, borrowed, or lent; and that is called interest. The Fed impacts our lives in more ways than we realize. They set the rates of interest charged and paid nationwide. By doing so they regulate the expansion and contraction of our whole economy. The Fed acts as a "funds clearinghouse" for financial institutions by matching those with excess deposits (more liabilities than assets) to those with excess loans (more assets than liabilities). This may seem backwards; but you must realize that on the books of the financial institution the debits and credits are effectively reversed. Loans are assets to them, and deposits are liabilities.

The Open Market Committee of the Fed meets monthly and sets the Fed Funds rate. This is the one at which banks lend funds to each other overnight, and the Fed keeps it on target by supplying as much liquidity as there is demand for at the targeted rate. The Fed supplements this inter-bank transferring of funds by supplying credits in its own right to institutions in need of further "liquidity." The Discount rate refers to the interest charged on these Federal Reserve "provided" funds. It rises (and drops) in sync with the Fed Funds rate but traditionally carries a 1% higher cost to the borrowing institution and hence to the ultimate borrower.

“Prime” (or prime rate) rate refers to the interest charged to borrowers with high creditworthiness and an established relationship to the lending institution. This reflects the cost of interest paid to the depositors, or the applicable rate paid to the correspondent institution/Fed plus a mark-up covering the lender’s administration costs and profit. Those not meeting the criteria for a loan at Prime pay an additional premium that depends on the perceived lending risk level. Prime generally rises (and drops) in sync with the Fed Funds rate.

Credit card rates are a defined in terms Prime plus a mark-up percentage. The mark-up can change at the discretion of the card’s issuer in accordance with their criteria and notification policies. LIBOR, the London Inter Bank Offered Rate, with no direct ties to the Fed Funds rate, is also used. Do you know how all your interest rates are determined, and why they fluctuate? You should! I’m Fred Cederholm and I’ve been thinking. You should be thinking, too.

Copyright 2005 Questions, Inc. All rights reserved. Fred Cederholm is a CPA/CFE, a forensic accountant, and writer. He is a graduate of the University of Illinois (B.A., M.A. and M.A.S.). He can be reached at

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This story was published on October 4, 2005.

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