What is an interest rate? It’s the cost of borrowing money from banks (lenders) and the reward for lending the money to others (borrowers). Banks do charge different interest rates to certain borrowers depending on relations with the customer and debt instrument. These interest rates do follow a certain pattern and benchmarking although slightly varying for different contracts. Interest rates vary for short-term and long-term contracts, but certain forces play a key role in determining the threshold or base interest rates. These rates then become the deciding factor in lending and borrowing for consumers and businesses.
The Federal Reserve Factor:
Governments around the world are interested in controlling interest rates that determine inflation and economic growth. The Federal Reserve or Central banking institutes issue a federal interest rate and determine an interest rate for interbank transactions. This minimum interest rate is referred to as the Federal Reserve rate or interbank lending rate, for example, LIBOR or FED Fund Rate in the UK and the US respectively.
Federal institutes require a minimum cash reserve from all licensed banks in the country. If any bank falls short of it or wants to earn interest with surplus cash they borrow or lend money to other banks. This short-term debt arrangement ranges from overnight to a few days. For banks, the use of this interest is to maintain the liquidity requirements and to make profits with short-term lending. The Federal Reserve aims to maintain a balance in inflation, economic growth, and interest rates. As the interest rates rise, the borrowing decreases, which slows down the businesses eventually. Similarly, increased Federal Reserve interest rates make borrowing for banks costly. Higher interest rates issued by the Federal also impacts the economy by decreasing the purchasing power of consumers. The Federal Reserve issuing central or Fed interest rate is interested in controlling interbank borrowing rates and controlling economic and inflation rates.
The Supply and Demand Forces:
So how are the specific interest rates for the lending and borrowing markets determined? The demand and supply for money play an integral role in determining the interest rates. Money demand refers to consumers applying for more borrowings for houses, vehicles, credit cards, and business financing facilities. As the money demand increases i.e. the demand for banking product (loans) it increases the interest rate (product price). Similarly, the opposite scenario also holds true for the money supply forces. Excessive supply of the product (loans) makes the interest rates to fall.
The demand and supply for bank borrowing depend on inflation and economic growth too. For example, higher inflation and a slower economy reduce borrowers’ repayment ability, which in turn compels banks to reduce the loan supply.
Note: The Federal Reserve also adjusts the fed fund rates to control inflation and interest rates. The demand and supply forces also get affected by the central bank or Fed interest rate decisions directly.
Retail Banking Lending Products:
Retail banks offer loan and mortgage facilities to borrowers depending on their total creditworthiness. For different types of lending products, the interest rates vary. Banks normally charge higher interest rates for unsecured or risky loans. Once again, inflation and economic conditions play an important role in these lending decisions. Higher inflation rates decrease purchasing powers and make borrowers unable to repay, banks considering these borrowers risky offer higher interest rates.
Retail banks sometimes, create a cushion for the borrowers with lower than market interest rates to lure in for selling their products. A similar scenario emerged in the mid-2000s which led to the global financing crunch in 2008.
Long-Term Interest Rates:
Long-term interest rates charged by retail banks to customers and other banks follow the long-term treasury rates. The Federal issues long-term treasury securities and bonds offering a pre-determined yield. The real interest rate on long-term bonds typically with a maturity time of 10, 15, or 30 years fluctuate depending on the demand-supply condition in the market. Banks seek long-term secured interest with Government backed bonds; hence often opt to invest in these secured investments.
Banks and financial lending institute offering long-term home equity loans and Mortgages invest in federal securities and bonds with long-term fixed income. The banks then offer these mortgage and long-term loan products to investors in the market. In a way, the rate offered on the treasury or government securities and bonds affect the rates of long-term retail bank loans. Any changes in bond rates also affect the stock markets, as investors make a comparison for returns with stocks and bonds.
Economic Growth Rate and Inflation:
The Federal government issued interest rates for the Federal Reserve rate and interbank rates, inflation, and economic growth are linked. The cycle starts from the top with a change in the Federal Reserve rates. The Federal will increase the interest rates if it wants to control the inflation to reach beyond control. An increased federal interest rate would mean expensive borrowings for businesses and individuals, less purchasing power and hence less spending in the market. Federal Reserve rate changes, however, affect economic growth or GDP inversely.
The government’s price focus is on controlling inflation and maintaining steady economic growth. For that purpose, governments often seek to create an optimum of Federal Reserve rates and inflation rates that directly affect the macroeconomic conditions of the country. We hope that you found out how are the specific interest rates for the lending and borrowing markets determined!