What Are Interest Rates? Who Decides Them? What Factors Influence Them?
The variables effecting interest rates in general are too numerous to list, mostly due to the fact that there are so many different types of accounts, products, and scenarios that have an interest rate attached to them. However, there are a few factors in common that affect all interest rates, regardless of the type or purpose of such rates.
The Federal Reserve’s Influence on Interest Rates
To begin, it is important that you understand how the U.S. government influences interest rates in an attempt to affect the performance of the economy on a larger scale. The Federal Reserve System (aka The Fed) is responsible for raising and/or lowering short-term interest rates with the intention of altering American consumer spending habits. The Fed was established in 1913 and consists of twelve Federal Reserve District Banks and seven members of the Board of Governors in Washington, D.C. This system was designed to be independent and unaffected by the constant changes in political climate. The goal of the system is to manipulate certain aspects of our economy, particularly interest rates, which are either the “cost” of borrowing money or the “profit” from saving money, and such influence is most notable during times of significant recession or depression. Such periods can be extremely detrimental to the financial stability of the public, and The Fed’s purpose is to help smooth out such peaks and valleys.
Lending Institutions Also Have an Influence on Interest Rates
Since lending institutions are largely responsible for the level of consumer spending in this country, their ability to offer loans (and the cost of such loans) will have a direct impact on the economy. When The Fed feels that consumer spending has increased or decreased to a level they are not comfortable with, one of the methods they may use to affect the economy is by increasing or decreasing the amount of reserves the banks must keep in the vaults. When this requirement is increased, there is less cash available to lend to the public, therefore an increased demand for loans results in higher interest rates. The opposite is true when The Fed reduces the minimum requirement of reserves, creating more available cash for loans and lower interest rates.
Federal Funds Market
With daily changes in the reserve requirement due to everyday banking by the general public, the amount of money needed for the banks to remain compliant with federal monetary policy is in a constant state of fluid change. There is not always enough money on hand for the banks to stash such reserves, therefore it is not uncommon for them to borrow from each other, even if for only a day or two. This short-term lending between banks occurs in a private financial market and is referred to as the Federal Funds Market. The interest rate on the loans between institutions is referred to as the Federal Funds Rate, and this rate will change with the level of supply and demand. The internal cost of these loans is passed down to the public in the form of an increase or decrease in the current going rate of bank loans, and this is why mortgage interest rates change on a daily basis.
What Does “Prime Rate” Refer To?
Perhaps the most well-known generic interest rate title that most consumers have heard of is the Prime Rate. Although the majority of consumers have no idea what the Prime Rate really is, or what it means to their own interest rates, it is a term they have become vaguely familiar with. Very simply, the Prime Rate is the interest rate that several major banks have agreed on as their rate for loaning money to other institutions. Interestingly enough, this rate is not always the lowest interest rate on the market, and therefore the Prime Rate is in the category of generic published rates, also known as Nominal Rates.
Each Lending Institution Calculates Their Own Rate
Without getting too much more complicated, it is interesting to note how the interest rates attached to consumer loans and accounts are determined by banks and other lending institutions. Calculating their own costs and profit margins entails a somewhat complicated formula, and each institution has some proprietary algorithms for this purpose. However, the basics of the calculation are very simple, and simply involve subtracting the expected rate of inflation from the published Nominal Rates (Prime Rate). Sometimes this results in a negative number, which means, for the most part, that there is significant profit to the banks, therefore consumers will experience looser cash flow and more readily available financing.
Several Components Affect Rate Changes
The Fed is not responsible for every fluctuation in interest rates, and there is no way to list, or even determine, what could possibly influence rates at any one particular lending institution. Described above are only the most major components to how and why rates change as they do. The smaller rate changes, from one day to the next and from one bank to the next, will always be due to a combination of The Fed’s requirements as well as the bank’s own internal financial status. The bank’s own internal accounting procedures and corporate policy will be responsible for the smaller shifts in interest rates, the number of loans permitted at any given time, and the total sum of available loanable cash.
