Interest Rates - A Matter of Supply and Demand

By Robert Rickles

When it comes to borrowing money, the interest rate on a loan should be one of the most important considerations in your buying decision. After all, the interest rate is really just the price you pay to borrow someone else's money. The lower the interest rate, the less costly it is to borrow

What Drives Interest Rates?

The price of borrowed money is determined in much the same way as the price of any other product or service - through the forces of supply and demand. When demand for money is high relative to supply, the price - or interest rate - goes up. When demand is low, the price comes down. The two primary drivers of interest rates are the health of the overall economy and government monetary policy.

"Here's to the Health of the Economy"

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In a strong economy, consumers feel more confident about their job security and businesses anticipate higher profits. Sensing better times ahead, consumers and businesses are more inclined to borrow money from mortgage companies and other financial institutions to make large purchases and investments. As more loans are made, however, the pool of funds available for loans shrinks. Higher demand for a smaller supply is a recipe for increased interest rates.

Of course, the opposite can also be true. A dimmer economic outlook can keep workers and businesses on the sidelines, lowering the demand for money and driving interest rates down. (What a great time to purchase a home and help turn the economy around!).

Monetary Policy – The Fed Strikes a Delicate Balance

The other primary interest rate driver is government monetary policy, which, in the United States, is managed by the Federal Reserve, or the Fed. As the nation's central bank, the Fed has the daunting task of maintaining stable prices, maximizing economic growth and keeping as many people employed as possible.

One of the levers the Fed uses in its work is the federal funds rate, the interest rate banks charge each other for short term loans. Depending on the direction of the economy, the Fed can raise or lower the rate, making it more or less expensive for banks to borrow to meet their short term obligations. These costs, in turn, are passed along to consumers and businesses in the form of higher or lower interest rates on loans.

The Fed's primary interest in setting the federal funds rate is keeping inflation in check. High inflation means rapidly rising prices, which can slow the economy and lead to layoffs, reduced spending by consumers and businesses and, potentially, a recession. The Fed, led by Ben S. Bernanke, can steadily raise rates over several quarters to stave off inflation in an overheated economy. So far the strategy seems to be working.

The other primary tool available to the Fed is the sale and purchase of government bonds. Backed by the full faith and credit of the United States, these bonds are considered very safe investments. When bond yields rise, investors snatch them up, leaving less money in the system to lend to consumers and businesses. The tighter money supply leads to higher interest rates and an economic slowdown. By buying and selling large quantities of government bonds, the Fed can inject or remove liquidity from the system, and in the process influence interest rates.

It's Still Pretty Much a Guessing Game

While the health of the economy and government monetary policy play a role in interest rate levels, the truth is that no one can predict with certainty what direction rates will go in next. There are just too many factors at play and too many unknowns awaiting the economy around the next corner. But, if you follow the trends closely and understand how interest rates are determined, you can improve your chances of making a good buying decision.