What Drives Interest Rates?

Hi All,

This posting is quick educational piece on interest rates. If you have a mortgage, a car loan, or a credit card, then you probably are concerned about interest rates. If you don’t, here is a hint: interest rates are essentially the price paid to borrow money.

But what causes interest rates to rise and fall? Well, it turns out there are several reasons for their fluctuations.

1. Federal Reserve Action: The federal reserve is the nations central bank and among other things, is responsible for setting interest rates. They use a variety of mechanisms to do this. But primarily the interest rate is determined by the Federal reserves’ Open Market Committee (FOMC), which sets the federal funds rate – or the rate that banks can charge each other for loans. When the federal reserve changes the federal funds rate, most other consumer rates change also.

Please note the federal funds rate is not the “prime rate” that you’re used to seeing on credit card and loan statements. The prime rate is a summary of rates charged by banks for favored or “prime” customers. Right now that’s big corporations.

2. Inflation: A second big factor impacting interest rates is inflation. When inflation starts increase, the Fed usually has to jack up the interest rate to slow it down.

3. Economic Activity: This is the major determinant of interest rates. The more economic activity there is, the greater the demand for money. Consider this, if the economy is healthy then there will be a need for more money to pay people, invest in improvements, and purchase consumer goods. When this happens, the federal reserve usually takes action to increase the money supply by lowering rates. Hence, economic activity is a root driver of interest rates.

Thanks,

James

p.s. If you like this “nuts and bolts” kind of stuff, check out our posting on the federal reserve.