Interest rates are influenced by the supply and demand for loans and credit in a free market and the direction that individuals, businesses, and governments take to save and spend their available funds.
In the U.S., interest rates are determined by the Federal Open Market Committee (FOMC), which consists of seven governors of the Federal Reserve Board and five Federal Reserve Bank presidents. The FOMC meets eight times a year to determine the near-term direction of monetary policy and interest rates.
- Interest rates are influenced by the supply and demand for loans and credit.
- Central banks raise or lower short-term interest rates to ensure stability and liquidity in the economy.
- Long-term interest rates are affected by the demand for 10- and 30-year U.S. Treasury notes.
- Retail banks control rates based on the market, their business needs, and individual customers.
How Short-Term Interest Rates Are Determined
Short-term interest rates are determined by central banks. A government's economic observers create a policy that helps ensure stable prices and liquidity. This policy is routinely checked so the supply of money within the economy is neither too large, which causes prices to increase, nor too small, which can lead to a drop in prices.
If the monetary policymakers wish to decrease the money supply, they will raise the interest rate, making it more attractive to deposit funds and reduce borrowing from the central bank. Conversely, if the central bank wishes to increase the money supply, it will decrease the interest rate, which makes it more attractive to borrow and spend money.
The federal funds rate is the rate banks charge each other for overnight loans. It also affects the prime rate—the rate banks charge their best customers, many of whom have the highest credit rating possible.
The U.S. prime rate remained at 3.25% between Dec. 16, 2008 and Dec. 17, 2015, when it was raised to 3.5%.
How Long-Term Interest Rates are Determined
Many of these rates are independent of the Fed funds rate, and, instead, follow 10- or 30-year Treasury note yields. These yields depend on demand after the U.S. Treasury Department auctions them off on the market. Lower demand tends to result in high-interest rates. But when there is a high demand for these notes, it can push rates down lower.
If you have a long-term fixed-rate mortgage, car loan, student loan, or any similar non-revolving consumer credit product, this is where it falls. Some credit card annual percentage rates are also affected by these notes.
These rates are generally lower than most revolving credit products but are higher than the prime rate.
Many savings account rates are also determined by long-term Treasury notes.
Deposit and Loan Rates: Retail Banks
Retail banks are also partly responsible for controlling interest rates. Loans and mortgages they offer may have rates that change based on several factors including their needs, the market, and the individual consumer.
For example, someone with a lower credit score may be at a higher risk of default, so they pay a higher interest rate. The same applies to credit cards. Banks will offer different rates to different customers, and will also increase the rate if there is a missed payment, bounced payment, or other services like balance transfers and foreign exchange.
For any individual loan, whether it be a personal loan or mortgage, or corporate bond issue, interest rates may deviate from the baseline rates set by the processes above. For instance, a high-risk borrower with a low credit score will pay higher rates on a loan with the same terms as a low-risk borrower with a high credit score. In addition:
- Longer maturity loans often have lower interest rates than short-term loans.
- Loans secured by collateral will have lower interest rates than unsecured debts.
- Bonds with embedded options will have higher interest rates than those that are non-callable.
The Bottom Line
Interest rates are determined, in large part, by central banks who actively commit to maintaining a target interest rate. They do so by intervening directly in the open market through open market operations (OMO), buying or selling Treasury securities to influence short-term rates. These rates, in turn, ripple out to inform many other rates on mortgage and auto loans corporate bonds to bank deposits. Ultimately, the supply and demand for loans and credit in the market will dictate interest rates over the long run.