What makes Interest Rates go up or down?

What makes Interest Rates go up or down?

The most simple question about interest rates might be what causes them to change. And yet, based on the many factors that affect the changing of interest rates, a reasonably acceptable – if not satisfactory – answer to this question could be as in depth and complex, as the question is simple. That having been said, our efforts throughout this article will be concentrated on several of those factors that affect interest rate changes, beginning with the money “supply and demand” element.

Money can be thought of as a commodity that is traded, exchanged, bought and sold like any other product or service on the market; but it is the “use of money” (borrowing) and “money usage” (lending for profit) that is more relevant to rate changes and therefore – for the purpose of this article – will be referred to interchangeably as we proceed. Over the past three decades markets have provided a good sampling of the money supply-demand process, during which time we've seen that when there is more of a demand for the supply of money, thereby reducing that supply, the cost – measured in terms of the rate of interest charged – increases; and when demand lessens the supply increases and costs decreases.

A more detailed description of supply and demand was expressed in the Wikipedia article 'Supply and demand' (last modified on June 5, 2014) which appears below:

The four basic laws of supply and demand are:

If demand increases (demand curve shifts to the right) and supply remains unchanged, a shortage occurs, leading to a higher equilibrium price.

1. If demand decreases (demand curve shifts to the left) supply remains unchanged, a surplus occurs, leading to a lower equilibrium price.
2. If demand remains unchanged and supply increases (supply curve shifts to the right), a surplus occurs, leading to a lower equilibrium price.
3. If demand remains unchanged and supply decreases (supply curve shifts to the left), a shortage occurs, leading to a higher equilibrium price.

Although many economists and other monetary experts believe that interest rate changes and other factors pertaining to money usage should be left to market forces, the central banks in many countries – including the Federal Reserve (the Fed) in the US – act contrary to this belief to control the money supply in their respective economies. This aspect of rate change causation is among the more complex, because it is not enough to state that interest rate changes are controlled by the Fed, since a more important question would be, why does the Fed find it necessary to change interest rates.

Therein lies the complexity, based on this statement from the PDF publication, 'Monetary Policy and the Economy' made available by The Federal Reserve Board:

The appropriate level of interest rates will vary with the stance of fiscal policy, changes in the pattern of household and business spending, productivity growth, and economic developments abroad. It can be difficult not only to gauge the strength of these forces but also to translate them into a path for interest rates. (Monetary Policy and the Economy, p. 23)

In other words, the Fed's view of reasons for change in interest rates depends on a number of factors which include, “the stance of fiscal policy,” changes in household and business “spending patterns,” growth in productivity (GNP), and global economic developments. While these factors affect interest rate changes, it is not practical in this article to presume that we know how the level of interest rates (interest rate changes) is determined by each factor, since only the Fed is in possession of all applicable variables that go into the equation.

Another factor that has a direct impact on the movement of interest rates is the fluctuation of bond yields in the sense that, as bond rates increases interest mortgage rates decreases, and the reverse is also true whereas when bond rates go down, interest rates go up. However, while bonds are more attractive to investors looking for less risky, long-term, steady return on their investments, they do exist in various different forms.

Chirantan Basu, in his article 'How Treasury Yields Affect Mortgage Interest Rates' states that “There is a strong correlation between mortgage interest rates and Treasury yields, according to a plot of 30-year conventional mortgages and 10-year Treasury yields using Federal Reserve Economic Data.” As a result, when the yield on these notes increases, banks and mortgage lenders are able to proportionately raise the interest rates they charge on home loans. So in effect, it is the rate at which Treasury notes (bonds) are sold that goes in the opposite direction to mortgage interest rates.