Interest rates — Fed, central banks, market rates

The most important number in finance

If forced to track only one number, you'd track the interest rate. Why? Because it shows up in every finance equation as the discount rate, and it ripples through every asset price. From bonds (direct math) to stocks (Gordon Growth's r) to mortgages (your monthly payment) to currency exchange rates (interest rate parity) — interest rates are the connective tissue.

But "the interest rate" isn't one number — it's a whole structure. Let's untangle it.

The central bank rate (e.g., the Fed Funds rate)

The starting point. In the US, the Federal Reserve sets a Fed Funds target range — a narrow band where overnight bank-to-bank lending should happen. The Bank of Korea sets a similar policy rate, the European Central Bank has its own, and so on.

This isn't a market price — it's a policy decision. The central bank changes it (or holds it) at scheduled meetings (the Fed's FOMC meets 8 times a year). When you hear "the Fed cut rates by 50 bp," it means the FOMC moved the target range down by 0.5 percentage points.

Market interest rates — the term structure

Once the central bank sets its overnight rate, the market sets all the other interest rates — for 1 month, 3 months, 1 year, 5 years, 10 years, 30 years. Each has its own rate, set by supply and demand for borrowing/lending at that maturity.

Plot rates against maturity, you get the yield curve. Normally upward-sloping (longer maturities have higher rates, because lenders want compensation for tying money up longer). Sometimes flat or inverted (when investors expect future rate cuts — Track 7 explores this).

The 10-year government yield is often called "the long-term rate" — it's the most-watched single point on the curve. The 2-year is watched for shorter-term policy expectations. The spread between the 2- and 10-year is a famous recession indicator (when 2-year exceeds 10-year, recessions often follow within a year or two).

Real vs nominal — the inflation correction

The interest rate you see quoted (like a 5% bank account) is nominal. Inflation eats into that — if inflation is 3%, your real return is roughly 2%. The math:

(Where π is the inflation rate. Exact formula uses Fisher equation: (1 + r_real) = (1 + r_nominal) / (1 + π), but the approximation is good enough for moderate values.)

Real interest rates matter more than nominal for purchasing power. A 10% nominal rate sounds great, but if inflation is 12%, you're losing real wealth. A 2% nominal rate sounds pathetic, but if inflation is 0%, your purchasing power is growing.

Why interest rates move everything

From last lesson and earlier in the quest: the discount rate r in valuation equations starts from r_f, which tracks the central bank policy rate plus a risk premium. So when the Fed moves rates:

• Bond prices change directly (Track 7).
• Stock valuations change because the discount rate moved (Track 6's Gordon Growth).
• Mortgage rates move, affecting house prices and consumer spending.
• Currency exchange rates shift (international capital chases yield).
• Corporate borrowing costs change, affecting investment plans.

Every Fed announcement that surprises the market causes wide ripples. This is why financial news watches the Fed obsessively.

The takeaway

Interest rates are a structure: central bank policy rate at the short end, market-set rates across the term structure (yield curve), real rates after subtracting inflation. The central bank moves the short end; the market moves the rest. Every asset price has the discount rate inside it, so when interest rates move, almost everything moves with them. Tracks 6, 7, and 8 all return to interest rate effects in detail.