How Interest Rates Are Determined

Who Decides?

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How are interest rates determined? They are determined by three forces. The first is the Federal Reserve, which sets the fed funds rate. That affects short-term and variable interest rates. The second is investor demand for U.S. Treasury notes and bonds. That affects long-term and fixed interest rates. The third force is the banking industry. It offers loans and mortgages and can change interest rates depending on business needs.

The Fed Affects Short-term Interest Rates

The Federal Reserve, also known as the Fed, impacts short-term interest rates. Two benchmarks for short-term interest rates are:

  • LIBOR: This is the rate banks charge each other for overnight loans to meet the Fed's reserve requirements. It is an acronym for the London InterBank Offering Rate. It is usually just a few tenths of a point higher than the fed funds rate. LIBOR is being phased out by the end of 2021, so the Fed is encouraging banks to stop using LIBOR. A committee convened by the Fed is recommending the Secured Overnight Financing Rate (SOFR) as an alternative.
  • Prime Rate: This is the rate that banks charge their best customers. It is usually above the fed funds rate, but a few points below the average variable interest rate. Interest rates affect the economy slowly. When the Federal Reserve changes the fed funds rate, it can take three to 24 months for the effect of the change to percolate throughout the entire economy. As rates increase, banks slowly lend less, and businesses slowly put off expansion. Similarly, consumers slowly realize they aren't as wealthy as they once were and put off purchases.

Stock market analysts and traders watch Federal Open Market Committee meetings, which are held eight or more times per year, closely. A 0.25 point decrease in the fed funds rate tends to increase stock prices because investors know that lowering interest rates will stimulate the economy. On the other hand, a 0.25 point increase in the rate can send stock prices down, as investors anticipate slow growth. Analysts pore over every word uttered by anyone in the Fed to try and get a clue as to what the Fed will do.

Different types of interest rates are driven by different forces. Variable interest rates are just what the name says; the rates vary throughout the life of the loan. The Fed raises or lowers the fed funds rate with its tools. Those changes have a ripple effect on other financial instruments like the Prime Rate. 

How Treasury Investors Affect Long-Term Rates

Rates on longer-term loans, such as 15-year and 30-year fixed-interest rate mortgages, are fixed for the loan's term. The same is true for interest rates on non-revolving credit. These are typically consumer loans for automobiles, education, and large consumer purchases like furniture. These interest rates are usually higher than the prime rate but lower than revolving credit.

Since these loans are typically one, three, five, or 10 years, they vary along with the yields on one-year, five-year, and 10-year Treasury notes. These interest rates don't follow the fed funds rate. Instead, they follow the yields on the 10- or 30-year Treasury Notes. The U.S. Treasury Department auctions these to the highest bidder. The yields respond to market demand. If there is a great demand for these notes, then the yields may be lower. If there isn't much demand, then the yields need to be high to attract investors.

The chart below illustrates the fed funds rate versus the 10-year treasury from the year 2000 through today.

How Banks Affect Other Types of Interest Rates

Until the housing boom in the early 2000s, variable mortgage rates changed in line with the fed funds rate. As the housing boom accelerated, new types of variable interest rate home loans were created. Some lenders varied the rates according to a schedule. During the first year, the interest rate might have been 1% or 2%, and then the rate jumped in the second or third year. Many people planned to sell their home before their interest rate jumped, but some were stuck when housing prices started to fall in 2006.

Even worse was the interest-only loan. Borrowers only paid the interest and never reduced the principal. The worst loan of all was the negative amortization loan. The monthly payment was less than needed to pay off the interest. Instead, the principal on this loan actually increased each month. This meant that loans increased to the point that borrowers owed more than their homes were worth.

Credit card rates usually have the highest interest rates of all. That's because credit cards require a lot of maintenance since they are part of the revolving credit category. These interest rates are usually several points higher than LIBOR or the Prime Rate.

Why Interest Rates Are Important

Interest rates control the flow of money in the economy. High interest rates curb inflation but also slow down the economy. Low interest rates stimulate the economy but could lead to inflation. Therefore, you need to know not only whether rates are increasing or decreasing, but what other economic indicators are saying. Here are a few examples:

  • If interest rates are increasing and the Consumer Price Index (CPI) is decreasing, this means the economy is not overheating, which is good.
  • If rates are increasing and the gross domestic product (GDP) is decreasing, the economy is slowing too much, which could lead to a recession.
  • If rates are decreasing and the GDP is increasing, the economy is speeding up, and that's good.
  • If rates are decreasing and the CPI is increasing, the economy is headed towards inflation.

Predicting Recessions

The 2008 recession was actually predicted by an inverted yield curve. This is when the Treasury Note long-term rates are lower than the short-term rates.

How Interest Rates Affect You

Interest rates impact any financial product you have. You might feel the most impact on a home mortgage. If interest rates are relatively high, your loan payments will be greater. If you are buying a home, this means you may need to purchase a lower-priced home to ensure you can afford the payments. Even if you are not in the market, if you own a home, your home value likely will not rise and could even decline during times of high interest rates.

On the other hand, high interest rates curb inflation. This means the price of other goods like food and gasoline will stay low and your paycheck will go further. If you were smart enough to lock in a fixed-interest rate loan at a low rate, your income will stretch even more.

If interest rates stay too high for too long, it can cause a recession, which creates layoffs as business growth slows. If you are in a cyclical industry, or a vulnerable position, you could get laid off. Although a recession can be difficult, it does eventually end, leading to new job opportunities as businesses begin to expand again.

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