why interest rates change

When interest rates change, it is the result of many complex factors. People who study interest rates find that it is as difficult to forecast future interest rates as it is the weather. Since interest rates reflect human activity, a long-term forecast is virtually impossible. After the fact, explanations are many and confident! Some of the major factors which help to dictate interest rates are explained below.

Supply and Demand for Funds

Interest rates are the price for borrowing money. Interest rates move up and down, reflecting many factors. The most important among these is the supply of funds, available for loans from lenders, and the demand, from borrowers. For example, take the mortgage market. In a period when many people are borrowing money to buy houses, banks and trust companies need to have the funds available to lend. They can get these from their own depositers. The banks pay 6% interest on five year GICs and charge 8% interest on a five year mortgage. If the demand for borrowing is higher than the funds they have available, they can raise their rates or borrow money from other people by issuing bonds to institutions in the "wholesale market". The trouble is, this source of funds is more expensive. Therefore interest rates go up! If the banks and trust companies have lots of money to lend and the housing market is slow, any borrower financing a house will get "special rate discounts" and the lenders will be very competitive, keeping rates low.

This happens in the fixed income markets as a whole. In a booming economy, many firms need to borrow funds to expand their plants, finance inventories, and even acquire other firms. Consumers might be buying cars and houses. These keep the "demand for capital" at a high level, and interest rates higher than they otherwise might be. Governments also borrow if they spend more money than they raise in taxes to finance their programs through "deficit financing". How governments spend their money and finance is called "fiscal policy". A high level of government expenditure and borrowing makes it hard for companies and individuals to borrow, this is called the "crowding out" effect.

Monetary Policy

Another major factor in interest rate changes is the "monetary policy" of governments. If a government "loosens monetary policy", this means that it has "printed more money". Simply put, the Central Bank creates more money by printing it. This makes interest rates lower, because more money is available to lenders and borrowers alike. If the supply of money is lowered, this "tightens" monetary policy and causes interest rates to rise. Governments alter the "money supply" to try and manage the economy. The trouble is, no one is quite sure how much money is necessary and how it is actually used once it is available. This causes economists endless debate.

Inflation

Another very important factor is inflation. Investors want to preserve the "purchasing power" of their money. If inflation is high and risks going higher, investors will need a higher interest rate to consider lending their money for more than the shortest term. After the very high inflation years of the 1970s and early 1980s, lenders had to receive a very high interest rate compared to inflation to lend their money. As inflation dropped, investors then demanded lower rates as their expectations become lower. Imagine the plight of the long-term bond investor in the high inflation period. After lending money at 5-6%, inflation moved from the 2-3% range to above 12%! The investor was receiving 7% less than inflation, effectively reducing the investor's wealth in real terms by 7% each year!