K
  • Interest Rates

    By Richard Carter, PhD
    Full-Time Faculty, Kaplan University
    Published July 2016

    Where Do Interest Rates Come From? 

    Interest rates represent the cost of money. As with most all economic theory, supply and demand is the cornerstone for the cost of money. Understanding the Federal Open Market Committee (FOMC) and its actions to manage the economy is the first step to find the source of interest rates. The process is as follows:

    FOMC Interpretation of Economic Conditions  

    Eight times per year the 12 Federal Reserve Banks, acting collectively as the FOMC, assess economic conditions in their respective districts. Retail activity, manufacturing growth, and rates of employment are examples of data collected. A summary of their economic assessments is presented in the FOMC Beige Book. If the FOMC Beige Book reports negative economic trends, the FOMC might consider taking actions to lower the cost of money to prompt economic expansion.

    The Process to Lower the Cost of Money  

    When the FOMC opts to lower interest rates the Federal Reserve Bank reduces your bank’s Federal Funds reserve rate. This is a percent of cash “your” bank must keep in their vault and cannot lend.

    As the Federal Funds reserve rate is lowered, “your” bank now has excess cash; it is the not-lent cash previously held in the vault due to the higher reserve rate. Banks are eager to lend this excess cash since loans earn a higher rate of return than cash reserves. Loans increase, the money supply increases, the cost of money goes down… an economic expansion begins.

    A Time to Forecast 

    The Composite Index of Leading Economic Indicators (LEI) offer clues of FOMC rate changes. The weekly LEIs note expected economic conditions about 6 months beforehand. Given this advance notice, you would have an expectation how the FOMC might alter interest rates. For example, a higher unemployment rate could suggest the FOMC will take action to lower interest rates in the future. A listing of the 10 Leading Economic Indicators can be found via the link below.

    Let’s say you are a Chief Financial Officer (CFO) who might be considering the financing of projects at a time of fluctuating interest rates. Much interest expense can be avoided when borrowings are timed when rates work in your favor. Naturally, this also holds true for mortgage rates. It could be costly for you to lock into a high rate for the life of your mortgage.

    Not a Crystal Ball

    A primary LEI is S&P 500 stock index trends. LEIs predicted stock market growth in 2008. However, the 2008 stock market crash caught the experts off guard. The crash destroyed $16.4 trillion of households' net worth from 2007 through 2009 and wiped out more than $2 trillion of retirement savings.

    Visit the FAQ section for additional information on interest rates.  

    Dr. Richard Carter is a full-time faculty member at Kaplan University. The views expressed in this article are solely those of the author and do not represent the view of Kaplan University. 

     

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