Most short-term interest rates are pegged to the movement of the overnight federal funds rate which is guided by the Federal Reserve Bank. The overnight federal funds rate is the inter-bank rate that banks charge to each other when they buy or sell money in order to cover their liquidity needs.
During periods of recession, the rates are low because banks have excess funds to invest. On the other hand, when money is tight due to increased economic activity, the rates increase.
Function
The overnight federal funds rate serves as the benchmark for short-term prime rate loans that banks charge to their best and most profitable customers. Whenever the Federal Reserve Bank changes the federal funds rate, banks immediately increase or lower their prime rates in direct proportion to the rate change. The spread between the overnight federal funds rate and the prime rate is 3 percent. On the other hand, the prime rate serves as the benchmark for many other types of short-term interest rates such as credit cards and floating rate loans.
Considerations
Consideration must be given to the fact that short-term interest rates do not provide protection from changes in the economy, especially during periods of inflation and expansion. For example, if your mortgage loan is based upon the floating short-term prime rate plus 3 percent, your obligation for interest payments will change whenever the prime rate changes. During periods of rapid economic growth, your mortgage payment could easily double. Therefore, the use of short-term interest rates for the funding of financial obligations should be taken into account before engaging in longer term strategies.
Types
Aside from short-term interest rates based upon the overnight federal funds rate or the prime rate, other types of loan categories exist that are priced upon supply and demand, risk and the usury laws of each state. These types of short-term loans are called pay day loans, cash advance and pawn shop loans. The loans are quite expensive and usually involve upfront fees of 2 to 4 percent plus very high interest rates. If at all possible, these short-term interest rate loans should be avoided.
Significance
As mentioned above, short-term interest rates serve as the bell weather for the economy as a whole and, as such, all other interest rates are affected. For example, the 10-year Treasury bond that serves as an important benchmark for mortgage loans, is responsive to the same economic movements that affect short-term interest rates. Therefore, the nature of short-term interest rates is to predict the future of the economy.