What makes interest rates go up and down?

Interest rates, as we all know, are what determines the cost of our mortgages, loans and sometimes, credit cards. But what makes them go up and down? What is the determining factors that make those grey haired men in corporate government palaces change the amount I pay on my mortgage each month?

I’ll try to help you easily understand why this happens in this post.

The Federal Reserve can manipulate interest rates by buying
and selling bonds in the bond markets. During economic times the Fed wants to
stimulate the market, the Fed buys bonds on the open market, and pays for the
bonds with cash. If the Fed continues buy bonds, the market becomes flooded with
cash. This excess cash in turn makes money more available for people who want to
borrow. The result is interest rates will naturally come down as different
lenders compete for a limited pool of borrowers.

The interest rate to borrow this excess money begins a bidding battle between different lenders each competing for the loan funds (so they can then lend to borrowers like you and me). Just like the most of us, borrowers go for the lowest price.

Interest Rates and A Growing Economy

When the economy is growing, consumers gain confidence, as their confidence
grows people start spending money. What do they buy? Everything under the sun
but consumer goods are the term you will hear most often. People buy items like
cars, computers, appliances like stainless steel refrigerators, etc.

This is the cycle of inflation, which in turn leads to increased interest rates:
1)    As demand for products increase, or more people buy stuff they don’t need, companies can begin to charge more for their products.
2)    When people want more stuff, companies make more money.
3)    As companies begin to make more profits it is not long before workers begin asking for more benefits and more money in their paychecks.
4)    As companies meet worker demands, the company experiences increased cost and expenses
5)    Then inflation begins.

Inflation is the prime cause of interest rate movement. To slow down any inflation, the government (Federal Reserve) starts selling those bonds they were buying before. Considering that the market was awash with cash when they were buying bonds, what do you think happens when they start selling?

That’s right! Money floods OUT of the market, and it makes it harder for lenders to get hold of money, hence the increase in costs to borrow. This then slows down everyone’s mad spending and slows down the economy.

PD

To read more about bonds and how they work, see this post