How Interest Rates Are Determined

Who Decides?

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Interest rates 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. They offer loans and mortgages that can change interest rates depending on business needs.

The Fed Affects Short-term Interest Rates

  • 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.
  • Prime Rate: What 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 rate immediately sends the market higher in jubilation because it knows that will stimulate the economy. On the other hand, a 0.25-point increase in the rate can send the market down, as it anticipates 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, they vary throughout the life of the loan. The Fed raises or lowers the Fed funds rate with its tools. 

How Treasury Investors Affect Long-Term Rates

Rates on longer-term loans, such as the 15-year and 30-year fixed interest mortgage rate, are fixed for the loan's term, either 15 or 30 years. 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 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 at all. Instead, they follow the yields on the 10- or 30-year Treasury Notes. These are auctioned by the U.S. Treasury Department to the highest bidder. The yields respond to market demand. If there is a great demand for these notes, then the yields can be low. If there is not much demand, then the yields need to be high to attract investors.

The chart below illustrates the fed funds rate vs. 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, they varied along with the fed funds rate. As the housing boom accelerated, new types of variable interest rate loans were created. Some varied the rates according to a schedule. The first year was 1% or 2%, then the rate jumped in the second or third year. Many people planned to sell their home before the interest rate jumped, but some got caught 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 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.

Credit card rates are usually 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 the Libor 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.

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

How Interest Rates Affect the U.S. Economy

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. The yield on the 10-year Treasury has since risen above 2% at times.

How Interest Rates Affect You

The most direct impact interest rates have is on your home mortgage. If interest rates are relatively high, your loan payments will be greater. If you are buying a home, this means you can afford a less expensive home. Even if you are not in the market, 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 loan at a low rate, your income will stretch even more.

If interest rates stay too high for too long, it causes a recession, which creates layoffs as businesses slow. If you are in a cyclical industry, or a vulnerable position, you could get laid off. 

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