Forces Behind Interest Rates

By Reem Heakal
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An interest rate is the cost of borrowing money. Or, on the other side of the coin, it is the
compensation for the service and risk of lending money. Without it, people would not be willing
to lend or even save their cash, both of which require deferring the opportunity to spend in the
present. But prevailing interest rates are always changing, and different types of loans offer
various interest rates. If you are a lender, a borrower or both, it's important you understand the
reasons for these changes and differences.
Lenders and Borrowers
The money lender takes a risk that the borrower may not pay back the loan. Thus, interest
provides a certain compensation for bearing risk. Coupled with the risk of default is the risk of
inflation. When you lend money now, the prices of goods and services may go up by the time
you are paid back, so your money's original purchasing power would decrease. Thus, interest
protects against future rises in inflation. A lender such as a bank uses the interest to process
account costs as well.
Borrowers pay interest because they must pay a price for gaining the ability to spend now,
instead of having to wait years to save up enough money. For example, a person or family may
take out a mortgage for a house for which they cannot presently pay in full, but the loan allows
them to become homeowners now instead of far into the future. Businesses also borrow for
future profit. They may borrow now to buy equipment so they can begin earning those revenues
today. Banks borrow to increase their activities, whether lending or investing, and pay interest to
clients for this service.
Interest can thus be considered a cost for one entity and income for another. Interest is the
opportunity cost of keeping your money as cash under your mattress as opposed to lending. If
you borrow money, the interest you have to pay is less than the cost of forgoing the opportunity
to have the money in the present.

How Interest Rates are Determined

Supply and Demand
Interest rate levels are a factor of the supply and demand of credit: an increase in the
demand for credit will raise interest rates, while a decrease in the demand for credit
will decrease them. Conversely, an increase in the supply of credit will reduce interest
rates while a decrease in the supply of credit will increase them.
The supply of credit is increased by an increase in the amount of money made
available to borrowers. For example, when you open a bank account, you are actually
lending money to the bank. Depending on the kind of account you open (a certificate
of deposit will render a higher interest rate than a checking account, with which you
have the ability to access the funds at any time), the bank can use that money for its
business and investment activities. In other words, the bank can lend out that money to
other customers. The more banks can lend, the more credit is available to the economy.
And as the supply of credit increases, the price of borrowing (interest) decreases.
Credit available to the economy is decreased as lenders decide to defer the re-payment
of their loans. For instance, when you decide to postpone paying this month's credit
card bill until next month or even later, you are not only increasing the amount of
interest you will have to pay, but also decreasing the amount of credit available in the
market. This in turn will increase the interest rates in the economy.
Inflation
Inflation will also affect interest rate levels. The higher the inflation rate, the more
interest rates are likely to rise. This occurs because lenders will demand higher interest
rates as compensation for the decrease in purchasing power of the money they will be
repaid in the future.
Government
The government has a say in how interest rates are affected. The U.S. Federal Reserve
(the Fed) often makes announcements about how monetary policy will affect interest
rates.
The federal funds rate, or the rate that institutions charge each other for extremely
short-term loans, affects the interest rate that banks set on the money they lend; the rate
then eventually trickles down into other short-term lending rates. The Fed influences
these rates with "open market transactions", which is basically the buying or selling of
previously issued U.S. securities. When the government buys more securities, banks
are injected with more money than they can use for lending, and the interest rates
decrease. When the government sells securities, money from the banks is drained for
the transaction, rendering less funds at the banks' disposal for lending, forcing a rise in
interest rates.

Types of Loans
Of the factors detailed above, supply and demand are, as we implied earlier, the primary forces
behind interest rate levels. The interest rate on each different type of loan, however, depends on
the credit risk, time, tax considerations (particularly in the U.S.) and convertibility of the
particular loan.
Risk refers to the likelihood of the loan being repaid. A greater chance that the loan will not be
repaid leads to higher interest rate levels. If, however, the loan is "secured", meaning there is
some sort of collateral that the lender will acquire in case the loan is not paid back (i.e. such as a
car or a house), the rate of interest will probably be lower. This is because the risk factor is
accounted for by the collateral.
For government-issued debt securities, there is of course very little risk because the borrower is
the government. For this reason, and because the interest is tax-free, the rate on treasury
securities tends to be relatively low.
Time is also a factor of risk. Long-term loans have a greater chance of not being repaid because
there is more time for adversity that leads to default. Also, the face value of a long-term loan,
compared to that of a short-term loan, is more vulnerable to the effects of inflation. Therefore,
the longer the borrower has to repay the loan, the more interest the lender should receive.
Finally, some loans that can be converted back into money quickly will have little if any loss on
the principal loaned out. These loans usually carry relatively lower interest rates.
Conclusion
As interest rates are a major factor of the income you can earn by lending money, of bond pricing
and of the amount you will have to pay to borrow money, it is important that you understand how
prevailing interest rates change: primarily by the forces of supply and demand, which are also
affected by inflation and monetary policy. Of course, when you are deciding whether to invest in
a debt security, it is important to understand how its characteristics determine what kind of
interest rate you can receive.
http://www.investopedia.com/articles/03/111203.asp

What factors influence an interest rate decision?

The Riksbanks target is that the annual change in the consumer price index (CPI) should be 2
per cent. This makes inflation developments an important factor for interest rate decisions. The
prospects for the real economy, for example economic growth and employment, are also
important for the interest rate decision. In the preparatory works for the Riksbank Act, it was
stated that the Riksbank, without prejudice to the price stability target, should furthermore
support the objectives of general economic policy with a view to achieving sustainable growth
and high employment. Monetary policy is unable to raise growth and employment more

permanently but it may affect these quantities in the short term. The best thing monetary policy
can do to attain sustainable growth and high employment is therefore to attempt to stabilise
production and employment around long-term sustainable paths besides stabilising inflation
around the inflation target, The Riksbank therefore conducts what is generally referred to as
flexible inflation targeting. This does not mean that the Riksbank neglect the fact that the
inflation target is the overriding objective.

How are the forecasts made?

How does the Riksbank forecast developments in inflation and economic growth? First, an
assessment is made of economic activity and inflation abroad, with a particular focus on
developments in Europe and the United States. Developments in the financial markets are then
assessed, including the exchange rate and interest rates. International price developments and the
exchange rate are important determinants since they affect price developments for goods and
services imported to Sweden. Finally, the Riksbank forecasts economic activity, which is a key
determinant of inflation.

Outline of how the Riksbank prepares an inflation forecast

The Riksbank uses a number of different models in its forecasting work. Time series models and
indicator models with strong forecasting capabilities are used to produce a first estimate of the
future path of economic activity and inflation. Structural models originating in national
economic theory are also employed to arrive at an overall assessment of the driving forces in
economic development. In addition, the Riksbank uses a large number of smaller models that
focus on important relationships in the economy. The advantage of the small models is that they
are capable of handling a larger number of details than structural models. The collective

information from all these models and other information are finally weighted together to produce
an economic and inflation forecast.

At the beginning of 2007, the Riksbank changed over to making forecasts for economic
developments in Sweden based on the interest rate path the Executive Board of the Riksbank
considers at that point in time to be most appropriate (see the boxed text below). Previously, it
was assumed that the repo rate would develop in line with market expectations. Earlier, forecasts
were based on the assumption that the repo rate would be unchanged during the forecast period.

The most important reason for publishing the Riksbanks own assessment of the future
development of the repo rate is that it will help the central bank to explain to the general public
and the financial markets how the Bank assesses the direction for monetary policy and thereby
future interest rate developments. It will become clearer what the Riksbank considers to be a
well-balanced monetary policy. This will make monetary policy easier to understand, to predict
and to evaluate.

In connection with every monetary policy decision, the Executive Board makes an assessment of
the repo-rate path needed for monetary policy to be well-balanced. A well-balanced monetary
policy is normally a question of finding an appropriate balance between stabilising inflation
around the inflation target and stabilising the real economy. The fact that the Riksbank tries to
stabilise both inflation and the real economy does not mean that it disregards the fact that the
inflation target takes precedence.

The exact horizon within which the Riksbank aims to ensure inflation is on target depends, for
instance, on the reasons why inflation is deviating from the target, the size of the deviation, and
the effects on the real economy. It can also depend on how much emphasis the Executive Board
members place on stabilising inflation on the one hand, and stabilising the real economy on the
other hand. In certain situations there may be reason to allow more time for inflation to return to
the target, as a rapid return could have undesirable effects on production and employment. But if
the return to the inflation target takes too long, on the other hand, there is a risk that the general
public will begin to doubt the Riksbanks intentions and ability to attain the target even in the
long term. It is important to avoid this happening. There is no general answer to the question of
how quickly the Riksbank aims to bring the inflation rate back to 2 per cent if it deviates from

the target. The Riksbanks ambition has generally been to adjust the repo rate and the repo rate
path so that inflation is expected to be fairly close to the target in two years time.

A desirable monetary policy should also be predictable in order to make it easier for households
and companies to adapt to new economic conditions. Changes in the repo rate should therefore
normally be made gradually and not in large steps. Moreover, changing the interest rate gradually
provides an opportunity to await and analyse new economic data. Since it is difficult to know
exactly how the economy functions and how monetary policy acts it is also beneficial that one
normally proceeds cautiously in changing interest rates.

However, it is important to emphasise that the Riksbank, in presenting its view of what is a
suitable path for the repo rate, has not committed itself to any particular future monetary policy.
As with all other assessments, the interest rate forecast will need to be revised on the basis of
new information received on economic developments in Sweden and abroad and the effects this
may have on the prospects for inflation and economic activity in Sweden. Therefore there is
always some uncertainty over future interest rate developments in the same way that there is
uncertainty over the general future development of the economy.
Print
Further reading

Riksbank to publish its own forecast for the repo rate. Box in Monetary Policy
Report 2007:1

http://www.riksbank.se/en/Monetary-policy/Forecasts-and-interest-ratedecisions/What-factors-influence-an-interest-rate-decision-/

5 Reasons Why Youre Getting That Interest Rate Today

By Jennifer Calonia

September 8, 2014

2 Comments

Interest rates today are speculated to remain at a

low well into 2015, which directly influences consumers ability to earn decent returns on deposit
accounts. Despite this reality, not many Americans truly comprehend how banks set interest
rates and what factors play a role in how rates change.
Bank interest rates arent simply determined at the whim of any given bank or credit union,
with no direction or benchmark. On the contrary, there are a handful of key elements that sway
interest rates today in consumers favor, or against it.

1. Federal Reserve Requirements

The Fed enforces a minimum reserve requirement, also called a cash reserve ratio, on banks that
are members of the Federal Reserve. These institutions are required to withhold a percentage of
their liabilities in either a cash vault or in a Federal Reserve Bank at all times.
Each year, the Fed assesses how much in cash reserves financial institutions must set aside; the
requirements are outlined in the Federal Reserve Boards Regulation D.
Reserve percentage requirements are based on a banks net transaction accounts (such
as checking accounts), which are as follows:

$0 $12.4 million: Zero percent in reserves

$12.4 million $79.5 million: 3 percent in cash reserves

Over $79.5 million: 10 percent in reserve requirements withheld

Why does all this matter? Banks that dont have enough depositors to uphold their reserve requirements have the
option to borrow funds from other banks through short-term loans to ensure the reserve requirement is met.

Banks are then charged interest by other banks on the loan, which is called the Federal Funds
Rate this cost of borrowing money is passed on to consumers via bank interest rates and
adjustments on loan products like auto and mortgage loans.

2. Discount Rate
The discount rate is another benchmark which determines how banks set interest rates. In
addition to giving banks the option to lend among one another, the Fed itself provides loans to
help banks meet the reserve requirement at a discount rate for the loan.
This direct loan from the Federal Reserve is typically higher than the Federal Funds Rate, but has
recently been lowered to supply institutions with a greater ability to provide loans to businesses
and consumers. The lower the rate banks have to pay when borrowing funds from the Fed, the
more affordable lending interest rates today are for consumers.

3. Anticipated Inflation
When financial institutions determine the deposit and loan rates offered to customers,
consideration is given to the potential inflation rate anticipated in the future.
Fergus Hodgson, Director of Fiscal Policy Studies for the John Locke Foundation in North
Carolina, shares why this seemingly convoluted concept makes a great deal of difference on
interest rates today.
Inflation, the devaluation of a currency expressed in higher price levels, is one of two
underlying drivers of retail interest rates the other is the activity of the Federal Reserve
system, Hodgson said. In the presence of higher inflation, which the United States is beginning
to experience, lenders need to raise their rates in order to generate a return. Relatively speaking,
the money they receive when paid back will be less valuable, which offsets the interest rate
charged.

As lenders attempt to compensate for the rate of inflation, borrowers will likely continue seeing
bank interest rates follow in suit.
Consider a mortgage loan at an interest rate of 5 percent, alongside an inflation rate of 2
percent. The real interest rate or return to the financial intermediary is 3 percent annually. If the
rate of inflation were to rise to 5 percent, the intermediary would need to offer comparable loans
at a rate of 8 percent for an equal return, Hodgson said.

4. Demand For Loans

The fundamental idea of supply and demand resonates strongly with how interest rates are set as
well. Since the economic recession, for example, fewer Americans have been financially capable
let alone willing to take on large amounts of debt, such as a mortgage loan toward a home
purchase. An over-saturated mortgage market (i.e. higher supply of mortgage loans) results in
lower loan rates due to a lack of demand. The reverse also functions in the same way.

5. Risk of Default
Lenders always take on a certain level of risk when lending money to borrowers. Those with a
history of late payments or poor credit, for example, will likely exhibit the same dangerous
financial behavior with a newly acquired loan.
For this reason, bank interest rates are increased on loans by financial institutions in an effort to
hasten and secure the return of their money in the event borrowers dont make good on their
promise to repay the loan within the predetermined term.
While a lot of the factors affecting interest rates today are out of consumers immediate control,
maintaining a clean line of credit and taking the initiative to shop around for the best bank
interest rates in the area opens the door to interest rates on deposit and loan products that meet
customers needs.
http://www.gobankingrates.com/banking/banks-set-interest-rates-today/

Factors Affecting Interest Rates

Generally, central banks seek to target low inflation. The ECB target 2%. The Bank
of England's inflation target is CPI 2% +/- 1. The most important factor in influencing
interest rates is whether inflation is likely to deviate from this target.

If the Bank forecast inflation to rise above the target, they will increase
interest rates to moderate economic growth and reduce the inflation rate.

If the Bank forecast inflation to fall below the target, they will cut interest
rates to boost consumer spending and economic growth.

Temporary Inflation and Underlying Inflation

In some circumstances the headline inflation rate may rise above the target, but the
Bank may choose not to increase interest rates. This is because they believe the
underlying (Core) Inflation rate is still close to the target. (see: difference between
CPI and Core CPI)
For example, in a period of commodity price inflation (e.g. rising oil price) or
increased taxes, the Bank may view this is a temporary factor. In this case it may be
more important to target economic growth and reducing unemployment - rather
than the spike in headline inflation.
For example, in 2011 we have inflation rising about the target in UK, EU and US.
But, this is primarily due to more temporary factors like rising oil prices, (and in UK
higher taxes and devaluation). If we strip away factors that tend to be volatile,
underlying inflation is lower and close to target. In 2008, inflation rose to 5% just
before recession and RPI later become negative.
A key test is wage inflation. If wage inflation is much lower than the headline rate,
this is an indicator that the temporary inflation is not feeding through into
permanent inflationary pressures.
See: Does temporary inflation lead to permanent inflation?
Priorities in Setting Interest Rates.
The ECB have indicated that they consider targeting inflation to be the most
important factor. Even if inflation is due to temporary factors, they prefer to
increase interest rates to prevent any potential of inflation.
The UK has taken a more relaxed view regarding inflation. CPI inflation recently
increased to 4.4% (well above upper limit of target) yet interest rates were kept at
0.5%. This indicates the Bank viewed inflation as a temporary phenomena and they
were more concerned about weak economic recovery and persistently high inflation.
However, this situation does prevent a dilemma for the Central bank; members of
the MPC have been split on this issue.
Key Factors Influencing Inflation / Interest rates

Economic growth rate vs underlying trend rate. If the underlying trend

rate is 2.5%, economic growth above this target is likely to cause inflationary
pressure.

Spare capacity. A key test is the amount of spare capacity in the economy,
though this can be difficult to calculate. For example, in a recession how
much potential capacity is lost?

Wage inflation. Rising wages lead to higher costs for firms and higher
spending. This is a very important factor as it can be self-reinforcing leading
to a wage price spiral.

Unemployment. High unemployment tends to depress wage inflation and

therefore keep inflationary pressure low.

Commodity prices. Rising commodities will tend to increase inflation.

However, some commodities have a tendency to be volatile meaning it is
more unreliable as a guide to underlying inflation.

Exchange Rate. A depreciation in the exchange rate will cause inflationary

pressures. This is because imports become more expensive, and there will be
greater demand for exports.

House prices. House prices don't directly influence the CPI. However, rising
house prices causes a positive wealth effect and therefore higher consumer
spending

Consumer confidence. Higher confidence leads to higher spending.

Related

Factors affecting economic growth

Interest rates explained

How the MPC set interest rates

http://econ.economicshelp.org/2011/05/factors-affecting-interest-rates.html

What influences interest rate movements?

Vikas Agarwal, ET Bureau May 31, 2009, 03.48am IST
Over the last seven years, home loan interest rates have come a full cycle. A soft interest rate
regime started towards the early part of this decade. Then, the interest rates started hardening
from the year 2006. Now, again, the interest rates have started going down, from this year. The
global economic slowdown triggered a softening in interest rates from last year.
Here too, exports started to drop due to the global recession. This had a negative impact on
consumer sentiments and hence they started cutting down on their expenses, especially on high
priced goods. This showed on the industrial output and therefore on a lower GDP. The Reserve

Bank of India (RBI) announced cuts in its key policy rates and ratios in October last to signal a
soft interest rate regime. Since then, in the last eight months, the RBI has further cut its key
policy rates and ratios many times to provide a stimulus to the economy and industry.

There are some important factors that govern the movement of interest rates. Potential borrowers
need to track these factors to get an idea on the possible movement of interest rates.
Economy
The general economic conditions are among the prime factors that influence the movement of
interest rates. In a growing economy, people have secure sources of earnings and hence high
confidence levels to borrow and buy. For example, people go in for a house, car, consumer
appliances etc. This increases the demand for funds. Hence, it influences the rate of interest in an
upward direction. In a recessionary economic condition or slowdown, the interest rates tend to go
down due to the opposite happening.
Inflation
The rate of inflation is another important factor that governs interest rates on loans. The lenders
prefer lending at interest rates that are higher than the rate of inflation. Otherwise, they will post
a negative growth in absolute terms. Therefore, a rise in the rate of inflation signals a higher
interest rate regime. On the other hand, a drop in the rate of inflation indicates a softer interest
rate regime.
RBI moves
The RBI governs the monetary policy. It controls the monetary activities such as money supply,
liquidity, and interest rates through its key policy rates - repo rate and reverse repo rate, and
ratios - cash reserve ratio (CRR) and statutory liquidity ratio (SLR). The RBI's key policy rates
act as a benchmark for the interest rates. Similarly, the policy ratios act as controls for the
liquidity in the system. The RBI keeps tuning these parameters based on the economic conditions
from time to time.
Stock market conditions
Corporates meet their needs of funds through equity expansions in the stock markets or
borrowings from financial institutions. Bullish trends in the stock markets prompt companies to
go in for the equity expansion route. This reduces the demand for funds through borrowing. On
the other hand, a sluggish stock market condition induces corporates to go in for the borrowing
route, and thus increases the demand for funds.
International borrowings

With the increasing globalisation over last few years, the economic conditions of international
markets have also started playing an important role in deciding the interest rate direction. The
global economic conditions influence the lending pattern of foreign investors to domestic
companies, and thus compete with domestic sources of funds in the market.
Fiscal deficit and government borrowings
The government policies and their impact on the fiscal deficit is another factor that influences the
interest rates indirectly. The government borrows money from the market to fund its fiscal
deficit. A rising fiscal deficit (as percentage of the GDP) indicates that the government will have
to borrow more from the market. This puts an indirect upward pressure on the borrowing rates in
the market.
http://articles.economictimes.indiatimes.com/2009-0531/news/27654163_1_interest-rates-repo-rate-cash-reserve-ratio

Factors Influencing Interest Rates

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An interest rate is the amount received in relation to an amount loaned, generally expressed as a
ratio of dollars received per hundred dollars lent. However, a distinction should be made between
specific interest rates and interest rates in general. Specific interest rates on a particular financial
instrument (for example, a mortgage or bank certificate of deposit) reflect the time for which the
money is on loan, the risk that the money may not be repaid, and the current supply and demand
in the marketplace for funds available for lending.
Some specific rates, such as those on Treasury or corporate bonds, are set in dealer markets by
negotiations between buyers and sellers, and are called market rates. These rates are subject to
change daily. Other rates, such as the bank prime rate (which is the interest rate that banks
charge their best customers) or the Federal Reserve discount rate (the rate at which banks can
borrow funds from the Federal Reserve) are set by some established group, and are known as
administered rates. But these administered rates would not exist for very long if they didnt
reflect some prevailing underlying forces. Ultimately they reflect market rates.
There are a number of forces that must be taken into account when attempting to evaluate the
current and future movement of interest rates. To begin with, interest rates are strongly
influenced by the condition of the U.S. economy. When the economy is growing, consumers have
jobs and savings to lend through banks, but they must also borrow for large items, such as homes
or cars, or to finance other purchases through credit cards. As the demand for funds increases,
interest rates rise and act as a ration for the funds available. Of course, the opposite is also true;
when the demand for funds is low, interest rates fall.

Inflationary pressures will also affect interest rates, because the rates paid on most loans are
fixed in the loan contract. A lender may be reluctant to lend money for any period of time if the
purchasing power of that money will be less when its repaid; the lender will, therefore, demand
a higher rate (known as an inflationary premium). Thus, inflation pushes interest rates higher;
deflation causes rates to decline.
The actions of the federal government have an effect on interest rates as well, because it is the
nations largest borrower. The federal government has first claim on available funds in the
marketplace. Because of its vast taxing powers and the strength of the U.S. economy, the federal
government has the highest credit rating and its debt is therefore a preferred investment.
International forces play an important role in influencing interest rates in the United States. To
the extent that foreign investors are willing to lend money to the U.S., they supplement domestic
sources of funds in the marketplace, driving interest rates down. If they were to decide to reduce
or sell their holdings in the U.S. and reinvest elsewhere, more needed funds would have to come
from domestic sources, which would push rates upward.
The dollar is the main currency in international trade and is used extensively in world markets.
Orderly fluctuations of the dollar in foreign exchange markets are essential for domestic and
international stability. Major or very volatile exchange rate movements could force the Federal
Reserve to act, as well as affect interest rates and U.S. monetary policy.
Changes in the condition of the U.S. financial system will also have a significant effect on
interest rates. If any large financial institution is threatened with collapse, it would not default on
the funds which are owed to its depositors, as was the case in the 1930s. The federal government
would take action to make good the deposits, regardless of the impact on the federal budget
deficit. The Federal Reserve would open bank reserves as necessary, increasing the supply of
funds in the market, and sending interest rates down, at least initially.
Its likely that the most important force to watch for evaluating future interest rate trends is the
Federal Reserve. The Fed, as it is known, controls credit availability (in other words, the
amount of funds available to lend) and the level of interest rates at which the funds are made
available. Its importance in the operation of the financial system is beyond the scope of this
article alone. Please read the article series The Federal Reserve for a more detailed discussion of
this topic.
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