Why Do Interest Rates Change? How Are They Determined?
Interest rates are a big deal in the global economy, from borrowing to savings accounts. But understanding why interest rates change and how they’re determined can be tricky. By breaking down the underlying factors and processes we can make sense of this important part of the financial system.
Interest rates are a big part of the financial system. They affect everything from borrowing to savings accounts. So they are important for everyone. But why do interest rates change and how are they determined? Knowing these answers and learning the underlying factors will help you make better financial decisions whether you’re saving or managing debt.
Why Do Interest Rates Change?
Interest rates move for a combination of economic factors and policy decisions. Let’s look at the main drivers behind these changes.
1. Inflation
Inflation means the general increase in the price levels of goods and services in an economy over time. As inflation goes up, the value of money goes down, which affects both savings and loans. To combat rising inflation, central banks raise interest rates.
- Why do interest rates go up when inflation goes up? Higher interest rates make borrowing more expensive, so there’s less money in the economy. When consumers and businesses pay more for loans, they’re less likely to spend freely, which slows down demand and reduces price pressure. For example, if inflation hits 5%, central banks may raise interest rates to 3-4% to stop borrowing, which can stabilize prices.
- What happens if inflation is low? If inflation is low or even negative (deflation), central banks may lower interest rates to encourage borrowing and spending. Lower rates make it cheaper for businesses to invest in growth and for consumers to buy things, which can increase the which can support economic growth.
In essence, inflation is a leading factor that central banks watch closely to decide whether to raise or lower interest rates, ensuring the economy remains balanced.
2. Economic Growth
Interest rates are linked to the overall economy. When the economy is growing, businesses invest more and consumers are more willing to borrow. In this case, interest rates may rise.
- Why does economic growth mean higher interest rates? During periods of strong economic growth, loan demand tends to increase whether for business expansion or consumer spending. Central banks may raise interest rates to avoid the economy overheating and inflation.
- What happens in a downturn? Conversely during a recession or economic slowdown central banks usually cut interest rates to stimulate growth. Lower interest rates make borrowing more attractive encouraging both businesses and consumers spend and invest more which can boost economic activity again.
Economic growth acts as a barometer for interest rate adjustments, with central banks aiming to balance growth and inflation to maintain a healthy economy.
3. Monetary Policy
Monetary policy is the actions of central banks to control interest rates and the money supply. Central banks like the Federal Reserve in the US set short term interest rates to influence the economy.
- How does it work? Central banks set the benchmark rate which is the rate at which banks lend to each other overnight. This rate then trickles down to influence other rates in the economy such as mortgage rates, personal loan rates and business loan rates.
- Why do central banks raise or lower rates? Central banks adjust rates based on their economic goals. If the goal is to restrain inflation, they raise rates to tighten the money supply. If the goal is to boost the economy during a recession, they lower rates to make borrowing cheaper.
Monetary policy is one of the most direct ways to influence interest rates, allowing central banks to control inflation and economic growth effectively.
4. Supply and Demand for Credit
Interest rates are governed by the basic economic principle of supply and demand. When more people and businesses want to borrow (demand) than there is money to lend (supply), interest rates go up.
- What happens when demand for credit is high? When demand for loans increases—like during an economic boom—banks may raise interest rates because there’s more competition for the available funds.
- What happens when the supply of credit is high? Conversely, when there’s more money to lend than borrowers, banks will lower interest rates to get more customers. This happens during an economic downturn when banks have excess funds but fewer people are borrowing. So you might see lower interest rates on personal loans and mortgages.
Supply and demand for credit reflect the overall financial climate, helping to explain why interest rates fluctuate over time.
5. Global Economic Conditions
Interest rates aren’t just determined by domestic factors, they’re also influenced by global economic conditions. In a globalised world, the policies and trends of other countries can impact interest rates in your own country.
- How do global factors impact domestic interest rates? If major economies like the U.S. or the EU raise or lower their interest rates, it can affect global capital flows. For example, if the U.S. raises interest rates, foreign investors may move their money into U.S. assets to get higher returns, which can put upward pressure on interest rates elsewhere too.
- Global interest rate coordination: In times of global financial crises or slowdowns, central banks in different countries may coordinate. For example, during the 2008 global financial crisis, central banks around the world lowered interest rates in sync to stabilise markets and support
Global factors, including trade, currency exchange rates, and international capital flows, are essential considerations in determining interest rate changes.
How Are Interest Rates Determined?
Now that we’ve covered why interest rates change, let’s get into how they’re actually determined. It’s a combination of policy decisions, market forces and economic conditions.
1. Central Bank
The biggest factor in setting interest rates is the central bank. In the US it’s the Federal Reserve’s Federal Open Market Committee (FOMC) that sets the benchmark rate.
- What does the FOMC do? The FOMC meets regularly to review the economy, including inflation, unemployment and GDP growth. Based on that data they decide whether to raise, lower or keep rates the same. For example if inflation is rising too fast they may raise rates to slow down the economy and bring inflation back to target.
Central banks are the primary decision-makers when it comes to interest rates, using their policy tools to guide economic activity.
2. Market Forces: The Bond Market
The bond market also has an impact on interest rates, especially long term rates like mortgages and corporate bonds.
- How do bonds affect interest rates? Government bonds like U.S. Treasury bonds are the safest of them all. The yield (interest rate) on these bonds is a benchmark for many other types of loans. When bond yields go up, other interest rates like mortgage rates follow. For example, if the yield on a 10 year Treasury bond goes from 2% to 3%, mortgage rates rise as well
The bond market serves as a key indicator of long-term interest rate trends, affecting borrowing costs across the economy.
3. Commercial Lending
While the central bank determines the rate, individual banks and financial institutions have some control over the rates they offer to consumers and business.
- How do banks determine their rates? Banks add a margin to the central bank’s rate based on the risk they perceive of a borrower. For example, someone with perfect credit may get a mortgage at 3% interest, someone with lower credit may get 5%. Banks also adjust their rates based on their need for liquidity or to compete for customers in a low interest rate environment.
Commercial banks’ lending practices set the rates consumers and businesses opposes, balancing risk and profitability.
Conclusion
Interest rates are moving and influenced by many things. Inflation, economic growth, monetary policy and global conditions all play a part in why interest rates change. Central banks are the main drivers through their policy decisions but market forces and commercial lending practices also come into play.
Knowing these helps you make informed decisions on borrowing, saving and investing. Stay on top of interest rate movements and you’ll be better equipped to navigate your financial condition whether you’re getting a mortgage, managing debt or planning your savings.
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