Interest rates on loans, investments and bank accounts are going to be rising this year. But what causes these increases anyway? You’ve probably heard about the Federal Reserve (“the Fed”) raising rates – Federal Reserve rising ratesmost recently on March 21. A Fed rate hike is definitely a factor, but it’s not the only one.
Interest rates rise and fall from two basic causes:
- Actions by the nation’s central bank, the Federal Reserve.
- The forces of supply and demand in the financial markets.
The rate you’ll hear about the Federal Reserve changing is its “federal funds rate.” The federal funds rate influences the rate at which banks lend money to each other in overnight borrowing. This affects other bank rates and rates in general. In practice, the Fed doesn’t just say,”Presto! The federal funds rate is this,” and banks start using exactly that rate. It announces a target federal funds rate and uses its influence to get banks to use something close to that rate, called the federal funds effective rate.
That federal funds effective rate basically sets the “prime rate,” which is what banks charge their best customers, and it’s often about 3 percentage points above the federal funds rate.
The federal funds rate influences short-term rates the most. Take for example, the federal funds rate and the rate on the one-year Treasury bond. They’re nearly identical. And the movements in the Fed funds rate affect variable interest rates. So, when the federal fund rate rises, so rates like credit card APRs.
What about the 10-year Treasury Bond?
But when it comes to long-term rates, those are set mainly by the markets. Right now the 10-year Treasury bond rate is rising. Mortgages are pegged to this rate, which explains why mortgage rates are rising.
Why is the 10-year Treasury bond rising? For a few reasons:
- The government is going to need to borrow more money by selling bonds to pay for rising deficits. To get investors to buy more bonds, it will have to entice them with higher rates.
- As the economy picks up steam, the demand for loans is rising, so lenders can charge more to lend money – and the “price” of money is interest rates.
- Rates tend to rise and fall with inflation, and inflation is starting to rise.
So, why is the Fed raising rates now? The Fed had kept rates artificially low to help businesses rebuild and expand since the financial collapse in 2008 and the Great Recession that followed. Now that the economy is doing much better, the Fed wants to return rates to “normal.” The Fed thinks around 3 percent is normal for the fed funds target rate. We’re now at 1.7 percent. Analysts predict the Fed will add 0.75 to its basic rate in 2018, getting us well on our way to that 3.0 percent rate in the next couple years.
To help the economy after the collapse, the Fed flooded it with money, which also lowered rates. This is because the price of something falls when there’s a lot of it. (Remember – the interest rate is the “cost” of money!) But now that the economy is doing well, the Fed is going to reduce the money supply gradually over the next few years, which will raise long-term rates.
How does this affect my bank or credit union?
As far as deposit rates paid by banks and credit unions, money market accounts, savings accounts and certificates of deposit generally follow the direction of interest rates influenced by the Federal Reserve and the markets. When these rates rise, savings rates are likely to rise, too.
But another factor is key: how much money banks and credit unions need. These financial institutions need deposits so they can lend that money out to make loans, such as car loans, mortgages and business loans. If they need more money for loans, they can attract more money by raising the interest rates they pay on deposits. They also compete with each other to attract deposits, which influences the interest rates they offer.
Given banks and credit unions have different needs for money at different times, shopping among them for the best rates on money market accounts, savings accounts and certificates of deposit is always a good idea.
There you have it – the highlights on why interest rates move. And while higher rates make loans more expensive, they do show the economy is doing better. Rates are still below historical averages. Plus, while savings rate increases tend to lag loan rate increases, they are rising, so savers will collect more interest after years of unusually low rates.
About the Author Robert Frick is the corporate economist for Navy Federal Credit Union. He holds a B.A. (Journalism) and an M.B.A. from the Pennsylvania State University, and was a financial and business journalist, including working as a newspaper business editor and senior editor for Kiplinger’s Personal Finance magazine. He was also editorial director of a financial publishing firm and is an expert in behavioral economics, having published more than 50 articles on the subject, and having worked as a researcher, writer and speaker for the Allianz Center for Behavioral Finance.