And that is important, because a rise in the federal funds rate will cause other, somewhat longer interest rates to increase as well.

China s Interest Rate Challenge

The Real Interest Rate Risk

So the Fed could, in principle, decide to raise the federal funds rate even before the unemployment rate reaches 6.5 .

And it is the real interest rate not the money rate that counts for economic growth.

With unemployment now at 7.6 and falling only slowly, the Fed may not be ready to raise the federal funds rate until 2015.

America s Interest Rate Puzzle

Lower interest rates are not a solution to this dilemma.

Because the inflation rate is also about 2 , this implies a negative real interest rate, which is confirmed by the interest rate of 0.6 on ten year Treasury Inflation Protected Securities (TIPS), which adjust interest and principal payments for inflation.

First, the Fed is trying to give relatively specific guidance about the future path of the federal funds rate (the overnight rate at which commercial banks lend to each other).

(The Fed raised its benchmark federal funds rate from 1 in 2004 to 5.25 in 2006 and held it there until August 2007).

According to the followers of Knut Wicksell, the central bank must keep the market rate of interest near the natural rate of interest.

In May 2006, the fairly free domestic interbank rate was just 1.62 , while the US Federal Funds rate was 5 .

As a result, the interest rate for 12 month fixed deposits has reached 3.9 .

At present, the interest rate is less than 0.5 .

The second adverse effect of deflation is to raise the real interest rate, that is, the difference between the nominal interest rate and the rate of inflation.

The Fed has signaled that its federal funds rate will remain near 0 , at least as long as unemployment exceeds 6.5 and inflation expectations remain well anchored.

But the interest rate that Greece must pay buyers of its government bonds has shot up to a record high level of nearly 9 5.9 percentage points above the benchmark rate paid by Germany.

The Fed warns that it might increase the federal funds rate if the anticipated annual inflation rate rises from its current level of a bit less than 2 to more than 2.5 .

Domestic deflation means that the real interest rate on Japanese bonds is higher than the nominal rate.

Foreign investors then sent their money to New York to take advantage of the higher rates.

However, this is no longer applied since the central bank started changing rates by 0.25 percentage points on October 19, 2010 (which was a rate increase).

But when prices are falling, the real interest rate exceeds the nominal rate.

In Japan, the ten year rate has drifted to below 0.8 .

And, due to rising consumer prices, the nominal interest rate will continue to rise.

Past experience implies that the real rate will rise to at least 2 , taking the total nominal interest rate to more than 4 , even if expected inflation remains at just 2 .

Since the interest rate set by the ECB is now less than 1 , there is little difference between its current monetary policy and what the Bank of Spain would do if it could set its own interest rate. But when the euro zone starts to recover, the ECB might choose to raise the interest rate before a higher rate would be appropriate for Spain, which could exacerbate Spanish unemployment.

All the above assumes that the interest rate remains constant throughout the whole period.

Indeed, the interest rate on inflation protected bonds has now become 0.5 , even for a five year maturity!

Given today s exceptionally low long term interest rates, the annual cost would be, well, peanuts.

Thus, the market can establish the necessary interest differential only if interest rates on yuan assets fall below their dollar equivalents.

So, if the PBOC sets the interest rate on one year deposits at 3 , commercial banks can offer depositors a rate as high as 3.3 .

But such an insignificant rate hike will do little to relieve long term pressures, because investors will expect more rate hikes and move money into China, increasing upward pressure on the yuan s exchange rate.

The interest rate on ten year Treasury bonds has risen almost a full percentage point since February, to 2.72 , implying a loss of nearly 10 in the price of the bond.

When the economic recovery begins to accelerate, commercial banks will want to use the large volume of reserves that the Fed has created to make loans to businesses and consumers.

This is intended to stimulate private spending by bringing down the rate of interest at which banks lend to their customers.

Yes, there is a minus sign in front of that if you buy the five year TIPS, each year over the next five years the US Treasury will pay you in interest the past year s consumer inflation rate minus 1.02 .

That predictable dollar decline makes the relative return on holding dollar bonds even lower than the interest rate differential alone implies.

The first, the Secular Stagnation Hypothesis, has been proposed by Larry Summers. Its key premise is that the equilibrium interest rate at which demand would balance supply is currently below the actual interest rate.

Likewise, the Bank of England keeps its policy rate at only 0.5 , despite an inflation rate that hovers above 2 .

A direct effect of the higher interest rate would be to increase the budget deficit and the rate of growth of government debt.

Monetary policy is now drawing on a more comprehensive toolkit, such as the policy rate, the interest rate corridor, required reserve ratios, and the reserve option mechanism.

Given the current expected inflation rate of 2 , the real rate on ten year bonds is still less than 1 .

Indeed, I would not be surprised by a continued rise in the inflation rate in 2015. In that case, the Fed is likely to raise the federal funds rate more rapidly and to a higher year end level than its recent statements imply.

In the United States, this interest rate is the federal funds rate in the United Kingdom, it is the official bank rate.