Where Do Interest Rates Come From?

By Teri | July 30, 2021

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Have you ever wondered how an interest rate is determined? Or do interest rates “just happen”?

Interest rates come in all shapes and sizes. There are short term rates and long-term rates. There are mortgage rates, rates for car loans and rates for credit cards.

There is the fed funds rate, the prime rate, and the overnight rate.

Who determines interest rates? Is there a who, or is there a what?

Interest rates are both a who and a what.

There is also a when. Can any of us know when interest rates are going to change?

The first thing to know about interest rates is that they have lots of relatives. It is a big family.

Every interest rate is related to another interest rate. It is the nature of the relationship between family members that determines how big or small an interest rate will be.

It’s like genome sequencing or a big family tree. There is a unique interest rate that is responsible for all the major events in our lives.

From buying or selling a home, going to college, buying a car or a dishwasher, interest rates are always there.

Let’s start with the Who of interest rates.

The Who is the Federal Reserve Board. The Federal Reserve Board is the central bank of the United States . There is a committee that forms the heart of interest rates. It is the Federal Open Market Committee ( also known as the FOMC ).

The interest rate that ultimately impacts all of us is known as the Fed Funds rate.

The FOMC decides on a target range for the Fed Funds rate. Currently the target range is 0.00-0.25%.

How they decide on the range is the answer to “where do interest rates come from ?”

Not out of thin air, no dartboards involved, no guessing allowed and no storks.

The FOMC analyzes every part of the economy to develop monetary policy which in turn produces the target rate for fed funds.

“Employment, inflation, and long-term interest rates fluctuate over time in response to economic and financial disturbances. Monetary policy plays an important role in stabilizing the economy in response to these disturbances. The Committee’s primary means of adjusting the stance of monetary policy is through changes in the target range for the federal funds rate.” [1] From the Statement on Monetary Policy July 9^th, 2021

“Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.” [2]

Now that we know the origin of an interest rate isn’t plucked out of thin air, what does this mean for you?

It means that borrowing money to finance major life events like buying a home, a car or a dishwasher is tied to the fed funds rate.

Here is an example:

Right now, housing prices are rising in some parts of the country. There are several reasons as to why, but the question many are asking is: Is it the right time to buy?

Some people would say “yes” because housing prices always go up . Right? Wrong.

Other people would say “yes” because interest rates are low. Better answer.

At some point the Fed WILL raise the target range for fed funds. This occurs when the economy is more “robust” than it is now.

When they do, mortgage lending rates will increase, and housing prices will.. ahem…retreat. As in go down.

I know 2008 seems like a long time ago but what happened in the housing market in 2008 is a caution against those who believe housing prices always go up.

The FOMC does not set the interest rate for mortgage loans. Mortgage lending rates represent conditions in the economy.

“Factors such as inflation, economic growth, the Fed’s monetary policy, and the state of the bond and housing markets all come into play.” [3]

If you follow the Fed Funds rate you will know if the FOMC is targeting higher or lower rates.

And what about all those relatives? You cannot forget about the relatives.

The relatives are the other interest rates like the interest rate on a treasury or corporate bond. The interest rate on a savings account.

There are the conservative interest rate relatives and the sky diving bungie jumping interest rate relatives.

The conservative interest rates are the “safer” rates. Treasury securities fall into this category.

How do you know?

We know that today the target for Fed Funds is 0.00-0.25%. The interest rate on a 10-year Treasury is 1.25%.The small difference of 1.00% means the risk is low if you buy a 10-year treasury bond . Lower interest rate, less risk.

If the interest rate on a 10-year corporate bond is 4% – RELATIVE to the 10-year treasury bond, the corporate bond has more risk.

Bungie jumper versus feet planted firmly on the ground.

When someone says, “Are rates going up” the answer is “ look at the fed funds rate.” If the FOMC has increased the target range, then yes rates are going up.

In May of 2000, over 20 years ago, the economy was smokin’ hot and the FOMC raised the fed funds rate to 6.50% ! [4]

Great news for savers. Not great news for borrowers.

You can follow the fed funds rate by clicking : Effective Federal Funds Rate (DFF) | FRED | St. Louis Fed (stlouisfed.org)