The Fed constantly evaluates several factors in relation to the discount rate, which it can raise or lower on a month-by-month basis. The most crucial of these factors is the inflation rate
The Federal Reserve (commonly known as “the Fed”) is the “central bank” of the United States. Unlike commercial banks, however, a central bank does not interact directly with the public. Its primary responsibility is to loan commercial banks money at a special interest rate called the discount rate. Your own bank profits when it gives you a short-term or long-term loan because the discount rare it pays to the Fed is lower than the rate it charges you.
The Fed constantly evaluates several factors in relation to the discount rate, which it can raise or lower on a month-by-month basis. The most crucial of these factors is the inflation rate. If the indications are that inflation is about to rise too fast, the Fed will raise the discount rate to make consumer loans more expensive. This, in turn, reduces demand for goods (like new homes) that would otherwise be purchased through loans and mortgages. The reduced demand will cause prices to drop and stabilize the inflation rate. Conversely, if the Fed senses that demand for goods and services is too low to stimulate the economy, it will lower the discount rate to encourage consumers to take out loans. This, in turn, raises demand, which raises prices and, consequently, inflation.
This is known as monetary policy, and economists who favor relying on the discount rate as a means for directing the economy are known as monetarists.
Another factor the Fed has to consider is the money supply, or the total amount of cash in circulation, known by economists as M1. Lowering the discount results in an increase in the M1. A second indicator monitored by the Fed is the M2, which also includes savings deposits, time deposits and money market accounts. Additional indicators exist as well.
As more and more consumers take out short-term and long-term loans, more and more cash is required by banks. The evidence indicates that the more money there is in circulation the easier it is for inflation to rise, which has the effect of cheapening the value of cash itself. This inevitably will also result in an increase in the interest rates consumers pay, especially for short-term loans, even if the discount rate does not rise as rapidly.
All commercial banks are members of the Federal Reserve System. This relationship is what allows the commercial banks to borrow money from the Fed at the discount rate. But the Fed has an additional tool at its disposal to control the lending capacity of commercial banks and your ability to afford the interest that you pay on your own loans.
No commercial bank is allowed by the Fed to loan out more than a certain percentage of the total amount of cash that it holds. That percentage is known as the capital requirement. By raising or lowering the capital requirement, the Fed exerts significant control over a commercial bank’s ability to grant new loans. If the capital requirement is raised, the bank will have to get pickier in deciding which loan applications will be approved, and how much of a loan it will be able to grant. As loans become more difficult to obtain, the interest rate will rise to discourage applicants, even if the discount rate remains unchanged. Short-term loans immediately become more difficult to obtain, since banks earn more money when the interest period is longer.
The interest rate charged for your short-term installment loan, therefore, is affected by all these factors. While CreditCube is not a commercial bank and is not subject to the restrictions set by the Fed, we are affected by the market like all other lenders. But we also strive to be sensitive to the needs of our customers and our interest rates reflect that commitment.