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 didn’t 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 it’s 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 nation’s 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.
It’s 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.